The sudden yield “taper tantrum” that began in the middle of February 2021 and took markets by surprise seems to have settled. While they remain elevated, investors appear to have accepted current yield levels as the new normal — at least for now. The key question now dominating the financial news cycle is whether these higher yields herald any inflationary concerns.
Against this backdrop, most government bond markets saw sharp selloffs in the first quarter, as prices dropped in proportion to the yield increase. However, there was one notable outlier — China.
Outlier among major debt markets
According to data from the Bloomberg Barclays indexes, of the 20 largest global debt markets, China’s was the only one to rise in the first quarter, with a 1% gain. Most of this increase occurred in March 2021, with bonds rebounding from weakness triggered by concerns about tighter monetary policy in the country.
Another factor playing in China’s favour was a lower correlation to other developed markets — a traditional strength of this asset class. This made the country’s sovereign debt a haven for foreign investors, who flocked to its bond market to escape surging yields. In the first three months of 2021, a net increase in foreign holdings of US$63.3 billion ($83.9 billion) was recorded, an 11% quarterly rise.
There is also the broader economic picture to consider. While markets everywhere have struggled amid the pandemic, China quickly returned to growth in the second quarter of 2020. It also managed to post a 2.3% annual expansion in 20203, followed by an impressive 18.3% y-o-y growth in the first quarter of 2021. All of this paints a favourable picture, as China’s bonds prepare to increase exposure on the global fixed income stage.
Inflows may surge with index inclusion
Starting in October 2021, index provider FTSE Russell will gradually absorb China’s sovereign bonds into its flagship bond grouping: the FTSE World Government Bond Index (WGBI). This phased inclusion will take place over three years and is expected to draw additional inflows of about US$3.6 billion a month from passive funds tracking the index. This is another potent catalyst for an asset class that has proved to be a resilient global yield play.
However, the lengthy run-in of three years reminds us that certain groups of investors remain somewhat cautious about engaging with China’s debt.
Balancing risks and returns
As China progressively opens its onshore bond market to the world, some inherent risks are coming under the spotlight. Lower liquidity in the off-the-run benchmark bonds, unfamiliarity with the bond access schemes, the documentation process and time taken to complete account opening, spot CNY FX execution availability not uniformly made available by all custodians in Bond Connect schemes are some of the issues that have made investors hesitant. Questions of transparency and, more broadly, geopolitical risks are factors to consider as well.
At the same time, the attractive yields offered by China’s government bonds make them hard to resist. The 10-year issues yielded about 3.2% at the end of April 2021, reflecting a 1.57% premium over US Treasuries. China’s current account surplus, now the largest globally, also acts as a safeguard against volatility — a positive point in a market where the sudden surge in yields is still fresh in investors’ minds.
The case of Japan’s Government Pension Investment Fund (GPIF) highlights this dilemma. As at end-March 2021, the US$1.7 trillion fund maintained zero holdings in renminbi-denominated bonds. The fund cited liquidity issues and foreign-investor restrictions as the main reasons for this lack of exposure.
It remains unclear whether the GPIF will strictly follow the WGBI index weightings once China’s sovereign bonds are included. The fund, while largely passively managed, is not required to adhere to the index weightings strictly. Excluding a key index component and its attractive yields means that it risks underperforming the market in an environment still dominated by the quest for yield.
Tipping the Scales
Certainly, there are risks associated with investing in China’s sovereign debt. So, the question we must ask is: are the returns worth the trade-offs?
When we take a step back and look at the bigger picture, the answer appears to be yes. China’s bond yields remain favourable, and the correlation to global assets are still low. Meanwhile, its strength is underpinned by a healthy economy, sizeable current account surplus, renminbi resilience, and a broad domestic investor base — about 97% of China’s domestic bond market is locally owned.
The current challenges may diminish as time passes. More significant foreign institutional investment could spur higher transparency and help accelerate the necessary regulatory reforms and financial infrastructure improvements. By focusing on the sovereign-debt market, investors can avoid the thorny issue of calculating the implied level of state support for certain corporate entities, especially with rising incidents of financial and liquidity challenges reported on a number of state-owned enterprises.
Kheng-Siang Ng is Asia Pacific head of fixed income at State Street Global Advisors
Photo: Bloomberg
