In these troubled times, every investor needs a good hedge against financial uncertainty in their portfolio. While such bulwarks are typically sought in Developed Market government bonds, a team of DBS strategists led by Eugene Leow are placing their bets on Beijing.
“It is high time to recognise that China government bonds (CGB) are a viable alternative to other DM govvies,” they declare bullishly, citing their potential as a hedging asset in an Oct 12 broker’s report. Hedges offsetting losses made in investment positions when prices fall, reducing the overall risk of an investor’s portfolio.
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Taking US Treasury bonds - a classic hedge play for investors - as a benchmark for “hedge-like” behaviour, the team sees CGBs exhibiting similar behaviour under financial stress. During the Global Financial Crisis and the Covid-19 recession, 10-Year CGBs provided capital gains to offset losses on risk assets. On a ten-year horizon, weekly correlation in 10-Year yields between treasury bonds and CGB is moderately high at 0.65.
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There is a risk, however, that by being too correlated with US Treasuries, CGBs become less effective hedges against risks in the US - a risk admittedly inherent in most government bonds. “During the taper tantrums of 2013, 10-Year CGB yields rose by about 100 base points for the year, about 80% of what 10-Year US yields did,” comments the team, noting that this reduced the ability of CGBs to diversify a portfolio. But with the People’s Bank of China (PBOC) looking to exercise more independence, future yields could be less correlated with the US in future, they speculate.
CGBs are also relatively good hedges in the domestic market as well. CGB 10-Year yields are inversely correlated with the CSI 300 and Shanghai Composite Index by 0.45 and 0.36 respectively compared to a negative correlation of 0.26 with the S&P500. AAA-rated Chinese Policy Bank Bonds (PBB) can surprisingly offer a hedge equivalent to CGBs at higher yields. PBB bond spreads remained stable or even compressed amid adverse risks such as the election of Donald Trump and the outbreak of US-China trade disputes.
The analysts also see the Chinese bond market becoming less volatile. While 7-Day repo has been historically volatile with swings of 600-800 base points within weeks 2011-2013, such violent swings have grown less frequent outside the year-end cross. Offshore rates reflected by the 6-Month CNH Hibor have also displayed significant stability since mid-2019.
Better yet, structural reforms from PBOC have seen improved access to CGB for foreign investors. For instance, PBOC recently combined the Qualified Institutional Investor (QFII, RMB) and the RQFII (offshore RMB) regulations. Not only has this simplified rules and application processes, foreign financial institutions can now conduct repo transactions and access derivatives in China.
“In practical terms, there are not many government bond markets that offer the combination of safety (hedging purposes), size, liquidity and returns,” observes the DBS team. DM bonds are becoming increasingly unattractive as real and absolute yields in the US, Japan and EU approach zero - with 10Y German yields closer to -0.5% - compared to the 3% offered by 10-Year CGBs, offering a real yield gap of real yield gap of 240bps in favour of CGB.
The low yield nature of DM bonds, moreover, make them less effective as risk hedges. With German and Japanese 10-Year yields approaching zero or even heading into negative territory, it is unlikely that they will have room to go any lower if the crisis worsens. US Treasuries fared somewhat better than CGBs, however, with 10-Year US Yields able to drop by another 70 base points even if the Fed chooses not to adopt negative interest rates.
CGBs may also serve as a useful hedge against a “Blue wave” - Democrats winning the White House and Congress - during the upcoming US Presidential Elections. “Should this scenario play out, the US Treasury curve could bear steepen further as election risks fade and the market focuses on the possibility of another sizable fiscal stimulus early next year,” the DBS team argues, explaining that CGBs are likely to be more stable should such a scenario arise.
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The main limitation of CGBs, however, is the PBOC’s continued neutral monetary policy. In contrast to most other central banks, PBOC tightened liquidity, driving onshore rates across the yield curve higher. According to the DBS team, this signals confidence in recovery and represents an attempt to pre-empt inflationary pressures and dampen speculation.
With the Chinese economy getting back online, the DBS team sees this neutral monetary policy continuing for the foreseeable future. They believe that tighter liquidity and further cuts in China’s Loan Prime Rate is improbable at present, with targeted infusions of liquidity likely going forward to ensure that short-term rates stay in range.
“While a neutral stance suggests that capital gains in CGB may be limited, we think that foreign investors will be interested in a safe 10Y tenor asset yielding in excess of 3%,” notes Leo and his colleagues. Foreign institutional ownership of CGBs has risen to about 9% of outstanding from about 4% in 2017, though still this is lower than the 35% owning US Treasuries. Despite still seeming like a “niche trade”, however, the team predicts that foreign ownership of outstanding will eventually rise to 20%.
