First in and first out - China as the vanguard for COVID-19 recovery
China’s path to normalisation offers guidance for other countries’ exit from the lockdown. Where are the opportunities for investors?
Sep 25, 2020
The onshore China bond market – discussed in this paper - has seen a significant broadening and deepening of issuance in recent years to become the second largest bond market globally, with a market capitalisation exceeding that of both German bunds and UK gilts. Index inclusions to flagship indices in 2019 and earlier this year have catalysed acceptance of this asset class into the investment mainstream.
China bonds provide investors with a diversified source of potential return and a significant yield premium compared with other asset classes. The decision by FTSE Russell to include China bonds in the WGBI is expected to inject another c$120bn of passive investment flows into China over the next two-to-three years. It also continues the mainstreaming of this asset class, evidenced by the country’s inclusion in other major bond indices such as the Bloomberg Barclays Global Aggregate Bond Index and the JP Morgan GBI EM Global Diversified Index. By including China, FTSE Russell acknowledged that ‘Chinese authorities have implemented significant improvements to the fixed income market infrastructure, facilitating easier participation by international investors. These market enhancements include: improving secondary market bond liquidity; enhancing the foreign exchange market structure; and developing global settlement and custody processes’.
Based on current projections, China’s eventual weight in the WGBI is expected to be c5.7%; similar to that of German bunds and above that of UK gilts.
In addition to these index-related ‘passive’ investment flows, we expect the trend of increasing discretionary investor allocations to continue apace, leading to even more flows into China. Offering an attractive risk premium, China bonds are generally less volatile than their global peers, while delivering a superior yield. They are also highly diversifying, reflecting the greater importance of domestic factors on the country’s growth and inflation dynamics, in contrast to other smaller emerging markets which may be influenced more by global trends. These attractive characteristics are rapidly gaining the attention of the global investment community.
With substantial foreign currency reserves and low external debt requirements, China should not be viewed as a conventional emerging market. We contend that China bonds, as an asset class, behave more like developed market fixed income. In a yield-starved world, this is an asset class that asset managers and investors alike simply cannot ignore.