Jun 1, 2021
China’s inclusion into major bond indices is an exciting step for this asset class. China is not a typical emerging market. As the world’s largest official creditor nation, China is highly rated, the renminbi exhibits lower volatility versus other foreign exchange markets and its fixed income markets act as a great diversifier to developed market bonds.
Wilfred Wee and Alan Siow, Portfolio Managers at Ninety One, discuss why this is an increasingly important asset class for investors’ portfolios.
As the world’s second largest bond market, China fixed income offers multiple investment opportunities with significant scope for growth. Domestic financial reforms and the opening-up of China’s capital account has enabled foreign investors to increase their allocations to Chinese bonds, which are now included in all major global bond indices.
In contrast with most international government debt currently registering negative real yields, China bonds supply a relatively high yield. In addition, the price behaviour of Chinese bonds is also usually less volatile, and as a result they have a superior risk-return profile. China’s high creditworthiness means that onshore CNY bonds also offer a relatively strong defensive profile to investors.
Offshore, Chinese USD bonds provide an attractive risk premium as credit spreads of Chinese companies have historically been up to 210 basis points higher than their BBB rated peers in the US2. When global markets have sold-off, offshore China bonds have often outperformed US credit spreads.
Another key benefit of an allocation to China bonds is that they provide a diversified source of returns. While diversification is a cornerstone of investing, it is increasingly hard to achieve, but because China’s growth and inflation outlook reflect domestic factors rather than global trends, this means that China bonds have a low correlation with major global risk asset classes. As a result, an allocation to China fixed income can potentially enhance a portfolio’s risk-reward characteristics by reducing overall portfolio volatility, while potentially increasing returns.
We expect the RMB to outperform its trading partners, albeit at a more modest pace after the significant rally in recent months, helped by exports boosting the trade surplus. Until outbound tourism picks up decisively, which we do not expect any time soon, the overall balance of payments is in China’s favour with the outlook for exports looking attractive. Headline geopolitical risks are also likely to de-escalate following the installation of a new US administration.
We expect that onshore CNY bond yields will remain range-bound, and possibly move higher as global COVID-19 vaccines are rolled out. Onshore CNY investment grade corporate bond yields can often be more attractive than their offshore USD investment grade counterparts and could provide attractive opportunities with less duration risk from time to time. For offshore Chinese USD bonds, we think that valuations have become rich and we see limited potential for capital gains. Most returns will come from holding higher yielding bonds over lower yielding ones, assuming prices remain constant. We prefer some select high-yield bonds with good underlying fundamentals and where valuations remain attractive over investment grade corporate.
We do not expect a meaningful increase in defaults in 2021 compared with 2020, but as recent volatility has shown, market sentiment can be fragile. Our process is to apply a rigorous bottom-up fundamental assessment of possible investments, and we do not consider an issuer unless we have carried out detailed credit analysis, which consists of a full financial model and investment note. We believe that our bottom-up fundamental investment process, combined with our in-depth industry and market experience has helped to avoid the problem issuers.
1Source: Bloomberg, JP Morgan, 31 December 2020. 2Source: JPMorgan, December 2020. Offshore, Chinese USD bonds: JPM Asia Credit Index – China; their BBB rated peers in the US: JPM US Liquid Index – BBB.