Sarman Keshwala

In the previous article in December 2020 on the China Bond market opportunity, I had explained the underlying factors supporting the case for investments into Chinese Government and Policy Bank bonds. As with every investment, timing is critical and there are near-term factors that dictate the performance of any asset class, which merit tactical shifts that investors need to make in their investment allocations.

Recap of the previous article and the Index inclusion developments on China Bonds.

In April 2019, Bloomberg commenced the inclusion of onshore China Government and Policy Bank Bonds into the Bloomberg Barclays Global Aggregate Index (“BBGA”). The inclusion was phased over a 20-month period starting April 2019. Then, JP Morgan announced that it will include China government bonds in its Government Bond Index – Emerging Markets (“GBI-EM”) starting February 2020. Lastly, in March 2021, FTSE Russell announced the inclusion of China Government Bonds into the FTSE World Government Bond Index (“WGBI”). The inclusion is to be phased over a period of 36 months starting Oct 2021.

Why is this relevant?

China Bonds is now the fourth largest currency component or approximately 6-7% of the Bloomberg Barclays Global Aggregate Index. The Index inclusion is expected to drive approximately US$150bn of flows into China onshore government bonds. JP Morgan has said the main index of the suite, GBI-EM Global Diversified has about $202 billion of assets benchmarked against it. The final weightage of China Bonds in this index is 10%, which means approx. US$20bn of inflows. And finally, the FTSE WGBI is widely tracked by a largely passive investor base (for instance – Japan’s $1.5Tn Government Pension Investment Fund uses the WGBI). With an eventual weight of 5.25%, the expected inflows are approx. US$130bn or about $3.6bn a month. In summary, the potential inflow numbers into the Onshore China Government and Policy Bank Bond market are gigantic and will have a weighty impact on that market and related ETFs.

Investors flooded the gates…

Let us first begin with a discussion on the quantum of flows into the China government bond space over the past couple of years, especially post the Bloomberg Index inclusion, starting April 2019.

Since the Bond Connect launch in July 2017, foreign holdings of China Bonds (Broad total including government) have increased from RMB882bn (US$136bn) to RMB3.67tn (US$570bn) as of May 2021 (an increase of US$434bn!). And more importantly, foreign holdings have increased approximately US$294bn since commencement of the BBGA Index inclusion from April 2019 – from RMB1.77tn (US$274bn) to RMB3.67tn (US$570bn) as of May 2021. Do note that the graph above represents foreign ownership in the broad China onshore bond market, but government and policy bank bonds anyways form the majority.

….And have been rewarded well so far !

The returns on the China government bonds and related ETFs have been quite attractive as well. The largest and most relevant ETF to perform an investment return analysis on, for this asset type, is the iShares China CNY Bond UCITS ETF (Ticker CNYB for the USD unhedged distributing class). The fund inflows over the past 12-18 months into this ETF were nothing short of staggering. The fund had a net inflow of US$4.6bn in 2020 and current net assets are close to US$11bn today. (Source: www.ishares.com and Morningstar). The chart below shows the returns over the last 1 year.

There is always a “However”…

However, the key point to understand for investors, is that the investment proposition into China government bonds and related ETFs essentially is a rates and currency play. Let us examine both these aspects a bit more.

Attractive Yield Premium

At a time when more than US$16tn of global bonds are negative yielding, an approximately 3% yield on A rated government debt sound very enticing. However, even with the alluring high yield and the one-way surge of inflows over the last couple of years into China government bonds, the investment proposition remains fairly sensitive to the state of US dollar rates.

For instance, the first chart below shows the CNYB performance between early Jan and Mar 2021 when US rates were spiking sharply. The second chart shows the 10-year US treasury yield during the same period, for comparison sake.

Also, if you look back at the chart above on foreign ownership of China bonds closely, you will note that foreign ownership in China bonds actually fell in Mar 2021 from RMB3,567bn to RMB3,558bn.

RMB Appreciation

Let us look at the second aspect now – Currency. The large capital inflows, together with the flourishing goods export post covid lockdown resulted in the RMB appreciating from about 7.1 per dollar to 6.37 at its best (end May). This appreciation further boosted the positive returns generated on the unhedged class of the ETF. However, there is a cloud of doubt over further RMB appreciation, and the currency has scaled back a bit in the last one month. This has a direct impact on the unhedged class return.

The first chart below shows the ETF return on an unhedged basis in the last month or so and the second chart shows the RMB depreciation during the same period.

Why is RMB movement especially relevant over the next 6-12 months?

The RMB has appreciated about 10-12% to its peak of 6.37 over the past 12 months and probably gotten to a point where it sits outside the comfort zone of the Chinese administration. China has been digging deep into its toolkit to dampen this rapid appreciation.

• Of late, China has been issuing fresh quotas under its Qualified Domestic Institutional Investor scheme. i.e. loosening capital controls to boost outflow
• PBOC recently increased reserve requirements for foreign currency holdings for financial institutions. i.e. squeezed dollar supply to pressure down the yuan
• In October last year, the PBOC removed reserve requirements for currency forwards. i.e. made it cheaper to short the RMB
• In October last year, Banks also started excluding a counter cyclical factor in their reference rates that they submit to PBOC. This factor was initially put in place to limit yuan weakness. (Source: Bloomberg)
• Lastly, there is “Southbound Bond Connect” on the horizon. Basically, the Southbound Bond Connect will enable mainland investors to buy offshore bonds which will further drive outflows from China.

So what is the summary then?

• The inflows into China government and policy bonds have been nothing short of colossal over the past 2 years
• The yield premium vs other comparable government bond yields, is very enticing
• These index-driven flows will likely continue over the next 1-3 years, albeit at a slightly decelerating pace compared to the last 12 months
• But even with the above factors, flows will remain sensitive to US Treasury rates
• RMB has appreciated significantly recently. With the recent macro-prudential and the capital control easing measures, investors need to watch out for RMB depreciation, especially if investing into an unhedged share class of the ETF
• Even if an investor is buying the hedged USD or EUR or GBP class, the cost of hedging needs to be taken into account which might eat away into the yield premium.

Happy investing!

To know more about the China Bond Market and the size, scope and nuances of this market, take our Fixed Income Analysis course and watch the video at the link below!

The China Bond Market – The Credit Balance

Disclaimer and Disclosure: Not meant to be investing advice ! Do your own research! I am long China government as well as corporate bonds. However, I might be doing tactical adjustments to portfolio allocations to this asset class. Also, do note the views expressed above, are strictly my own and have nothing to do with the collective organisational views of my employer.

Inflation expectations, transient inflation, base effects, lift off, thinking about thinking about hiking – These and a dozen more phrases / words have been dished out in bountiful quantities in financial media in the past few months.

While some emerging markets like South Africa, Turkey, Brazil, Russia might see monetary tightening in response to growing inflationary pressures, these are not ideal comparables, from a monetary policy appropriateness perspective, to either the US or UK or other developed economies. In contrast, developments in the monetary policy space in Australia merit a deeper consideration. During the last global crisis in 2009, Australia was one of the first countries to hike rates in October 2009 in response to faster growth (partly attributable to China’s growing import of commodities) and the prospect of rising inflation then. This time around though Australia has been on par with, if not ahead of, other major economies in deploying its fiscal and monetary firepower.

The RBA is expected to decide in its July 6th meeting if it will extend the “Yield Curve Control” (YCC) target to the Australian Government Bond maturing in November 2024. The RBA is also expected to announce if it plans for even more QE. i.e. more longer-dated bond buying, with the current AUD100 billion tranche likely to expire in September 2021.

For the uninitiated, here is a quick overview of YCC. Yield Curve Control is a rather unconventional monetary tool where the Central Bank targets to maintain yield for a certain tenor (0.1% and 3 years in the case of RBA). In very simple words, it is a blank check with no fixed quantity which promises that the Central Bank will buy as many government bonds of that maturity that it might deem necessary to maintain the yield at a certain level. It is supposed to aid maintaining lower interest rates in the economy, boost borrowing and economic activity and spur growth. Whether that works or not, is not the topic of debate of this article.

First quick recap of Australia’s macro-economic data in recent weeks. The top 4 statistics to follow are –

1Q 2021 GDP outperformed expectations at 1.8%	The RBA’s central scenario expects GDP to grow 4.75% in 2021 and 3.5% over 2022
The unemployment Rate decreased 5.1% in May 2021	The RBA has acknowledged the rapid progress in employment numbers and even acknowledged labor market tightness in some sectors
Consumer Price Index grew 1.1% in 1Q 2021	The RBA’s central scenario expects inflation to be around 1.5% in 2021 and 2% in mid-2023
Wage Price Index grew 1.5% in 1Q 2021	That is half the rate that the RBA said is needed to generate inflation

The investing community eagerly awaits the RBA’s preferred path forward. In the context of these Australian Fixed Income space developments, below is a quick primer on Australia’s macro-economic health and key risks, explained in 3 short chapters.

Chapter 1 – Is Australia’s public debt very high and who is lending to the Australian government?

Total outstanding Australian Government Securities (also called AGS) are AUD 881bn as of 31 March 2021. At approximately 38% of GDP, Australia’s general government net debt is still far lesser than other comparable developed economies like the UK, US, France, Italy and Japan. But there are some nuances to consider in Australia’s case which makes it a bit different than the aforementioned countries.

Foreign ownership of AGS stands now at approx. 50%. So roughly AUD443bn out of the total AGS pile of AUD881bn is held by foreign investors. (Source: www.aofm.gov.au). Japanese investors including the large pension funds are one of the largest foreign holders of AGS. This flow has especially increased since 2020 after rates have crashed all around the world. Rolling 12 month net inflows into AGS by Japanese investors have been approx. AUD40-50bn since mid 2020.

First takeaway – Even though Australia’s net debt is significantly lower compared to other developed economies like Japan, the % of foreign ownership is significantly high and that exposes AGSs to the whims of foreign investors.

Chapter 2 – Given that foreign holdings of AGS are high, what is Australia’s net international investment position?

Australia’s success and wealth is significantly attributable to its abundance of resources, primarily iron ore, coal, petroleum and copper. Especially post 2000, as the world and more importantly China notched up industrial activity, Australia found itself in a sweet spot to be able to capitalize on this surge of demand and increase in prices of these commodities. These booming exports aided significant GDP growth. This led to lower unemployment, higher wages, higher government revenue and increased shareholder profits. All in all, it resulted in significant wealth creation domestically. However, this huge demand for commodities also correspondingly meant a higher level of investment into the commodities sector. In other words, this also meant a significant rise in imports of investment goods to boost the capacity of the resources sector. This, together with consumer / final goods imports and a primary income deficit, has kept Australia’s current account in deficit for a large part of the last two decades.

Unsurprisingly then, given the current account deficit and the attractive investment opportunities in Australia which incentivize the flow of capital into the country, Australia has built a negative Net International Investment Position (“NIIP”) over the years. Australia’s NIIP is a negative AUD875bn as of March 2021. In summary, Australia owes foreigners more than it owns in foreign assets. And quite substantially! In contrast Japan’s NIIP is a positive US$3.7Tn.

Here is a further breakdown of Australia’s net liability position. Australia’s net foreign debt was approx. AUD1,140bn as of 31 Mar 2021. This is the net position of debt securities from Australia’s perspective. In other words, the amount by which foreign residents’ ownership of Australian debt securities exceeds Australian residents’ ownership of foreign debt securities is AUD1,140bn. As I explained before, a significant portion of this number includes the AGS held by foreign residents, (approx. AUD443bn), which has grown substantially in recent years. This also includes the debt securities within the financial and corporate sectors in Australia. However, on the other hand, Australia also has a positive position in Net Foreign Equity. In other words, Australian residents owns more foreign equity than foreign residents own equity in Australia. As of Mar 31, 2021, net foreign equity was a positive AUD264bn. This can be largely attributed to the successful superannuation funds in Australia which have channeled domestic savings into foreign equities, especially during the last 7-8 years.

Second takeaway – Australia has a large negative NIIP. i.e. a net liability position vs. the rest of the world. Traditional economics deems this to be a risk. While Australia has been a beneficiary of a commodities led export boom, the current account balance has generally been in deficit resulting in this large negative NIIP. Overseas ownership of Australian government debt has increased with more investments from overseas central banks and Japanese pension funds. Superannuation funds are building a large foreign asset portfolio.

Chapter 3 – Is Australia’s International Investment Position Liability really a risk?

However, the headline NIIP numbers hide another interesting underlying story. Firstly, the net foreign debt that Australia has built over the past years is more long term in nature. This reduces the risk of short-term outflow shocks. The mix between long-term and short-term debt has been changing favorably in the past years attributable to the fact that a large part of these Australian liabilities are the long term Australian Government Bonds as opposed to the Australian financial sector borrowing from overseas. Second and more importantly the bulk of the liabilities (both debt and equity instruments) are denominated in AUD. Hence the country is not significantly exposed to foreign currency risks. All of the Australian government bonds are denominated in AUD and a large portion of the borrowings of the banks and corporates tends to be either denominated in AUD or denominated in a foreign currency and hedged back to AUD. On the contrary, Australia’s foreign assets (both debt and equity instruments) are mostly denominated in foreign currency. Hence as a whole, Australia has a net foreign currency asset position. In summary, in the event of AUD deprecation, Australia’s foreign asset position improves further since the AUD value of the foreign currency denominated asset increases and likewise, the dollar value of Australia’s AUD denominated liabilities decreases.

Third takeaway – While Australia’s NIIP is a large liability, the mix of exposure is mostly long term in nature, eliminating the risk of short-term outflow shocks. Also, Australia’s has a net asset position in foreign currency denomination and hence generally stands to benefit from an AUD depreciation event.

Australia is said to be the lucky country and prior to this pandemic induced recession, Australia had gone recession-free for a record 30 years. A large part of that record performance was attributable to external factors (like China’s colossal growth) and Australia was just in the right place at the right time. Circumstances are a bit different now. Even though commodity prices have rallied in the past 6 months or so, another large, extended, externally induced mining boom is unlikely. The government is ramping up fiscal incentives to spur domestic growth. Other services led export opportunities like tourism and education are more center-stage from a longer term perspective. How the lucky country performs from here on will be a thrill to watch. And so will be investors view of the Australian Fixed Income Securities.

Happy investing!

To learn more about the various types of bonds and fixed income instruments, take our Fixed Income Analysis course and watch the videos at the link below!

Fixed Income Securities – The Credit Balance

On June 2nd, 2021, the Fed announced that it will be selling off its Corporate Bond and Corporate Bond ETF Portfolio. If you recollect, in March 2020 at the start of the mayhem during the virus pandemic, the Fed had initiated a slew of market stabilizing measures – one of which was the SMCCF – or the Secondary Market Corporate Credit Facility. The SMCCF was established with the objective to support employers by providing liquidity to the secondary market for corporate bonds. The SMCCF provided liquidity by purchasing either corporate bonds of investment grade companies or corporate bond US listed ETFs.

A bit more on the mechanics – The way the transaction structure works is that the Treasury sets up an SPV and injects it with equity. In this case, the Treasury agreed to make a US$75bn equity injection. The US$75 was intended to be towards both the SMCCF as well as a Primary Market Corporate Credit Facility intended to buy investment grade corporate bonds in the primary market, directly from companies issuing those bonds. The Fed, through the Federal Reserve Bank of New York (“FRBNY”), then lends to this SPV at a leverage ratio of 10:1. The SPV thus has effectively buying power of $750bn. The loan provided by FRBNY to the SPV is collateralized with both, the assets purchased by the SPV as well as the equity injected by the Treasury into the SPV.

I was asked 2 questions recently. First, whether the sale announcement and the sale would have any impact on the corporate bond or corporate bond ETF market? Second, whether this announcement would be viewed negatively by the markets, generally, for risk assets?

The SMCCF was initiated on 22 Mar 2020 and began buying assets on 12 May 2020. The Fed stopped buying assets under this facility on 31 Dec 2020. The SPV has approx. $14billion in assets acquired during the period of operation. So, in summary, starting June 7th the Fed will start offloading these US$14bn of corporate bonds and ETFs in the secondary market. Just by way of comparison, the total corporate bond market size in the US is more than US$10Tn (Source: SIFMA as of 1Q 2021). Basically, the Fed’s corporate bond portfolio is a drop in the ocean. For fun sake, here is a graphical representation, drawn to size !

Second, while there are legitimate views or concerns on whether the Fed unwinding a pandemic response facility sends a tightening signal to the market, I find it hard to digest that any market participant can reasonably call this move tightening at a time when the Fed is still buying US$80bn of US Treasuries each month and US$40bn of Mortgage Backed Securities each month. With almost 2 weeks having passed since the Fed’s selling announcement, during which the corporate bond market has shown minimal ripples, this view seems to be vindicated. The facility was set up at a time of extreme market stress and with that stress having disappeared more or less, it is only appropriate that the Fed packs back this tool kit to be reopened selectively and judiciously only in extreme events which truly require the use of these unconventional tools.

More interesting though, is that fact that the Fed and consequently the Treasury (i.e. the tax payer), will likely make a net gain on the SMCCF overall. Markets and asset prices have recovered since the lows of March 2020.

This brings me to the story of a few similar transactions that were conducted in 2008, during the height of the Global Financial Crisis. Invariably, the wider public seems to only remember the fact that tax payer money was put to use to bail out institutions like AIG and Bear Stearns (to facilitate JPM’s purchase of Bear Stearns). But how many of us really followed the sequence of events right till the very end when these Fed support facilities were fully unwound and money paid back to the tax payer’s account at the Treasury. Here is a quick summary of three such transactions that were conducted at the height of the GFC.

The First Maiden Lane

Bear Stearns was in deep trouble in March 2008. JP Morgan eventually purchased Bear Stearns, but only after the Fed had agreed to buy $30bn of “toxic assets“ off the Bear Stearns portfolio. Maiden Lane LLC was created in March 2008 and was funded with a US$29bn loan from the FRBNY and a $1.15bn subordinated loan from JPM. Collectively, with US$30bn of funds, Maiden Lane LLC purchased a portfolio of Agency Mortgage Backed Securities, Commercial Real Estate Whole Loans, Non-Agency Mortgage Backed Securities and other such related assets including derivatives from Bear Stearns. JPM, then bought the rest of Bear Stearns at $10 a share. Maiden Lane LLC, progressively over the next few years sold these assets in the secondary markets. The Fed loan of US$29bn was repaid in June 2012. The last of the securities under Maiden Lane LLC were sold as recently as 2018. Cumulatively, the Fed realized a profit for the US tax payer of US$2.5bn including the interest FRBNY received on the loan to Maiden Lane LLC.

The Second Maiden Lane

Post Lehman’s collapse in Sep 2008, all hell broke loose. The next likely casualty on the block was AIG. Maiden Lane II LLC was the next SPV to be set up to facilitate the government’s financial support to AIG. Once again, the Fed through FRBNY, lent US$19.5bn to the SPV. Armed with a total of US$20.5Bn of funds, which included a deferred note from AIG, Maiden Lane II LLC purchased US$20.5bn of Residential Mortgage Backed Securities from several regulated insurance subsidiaries of AIG. The transaction was valued on 31st Oct 2008 and effectively Maiden Lane II LLC held a portfolio of RMBS securities that had a fair value of US$20.5bn and a par value of approx.. US$39bn. The SPV then sold these securities in the secondary markets through competitive sales processes. The last of these securities were sold in Feb 2012 and the American tax payer derived a net gain of US$2.8bn including the interest received by the FRBNY on the loan to the SPV.

The Third Maiden Lane

I had just begun my career on Wall Street, right when the 2008 financial crisis struck. It was both, enthralling and intimidating, in equal parts. There were just so many lessons to learn. One of the most fascinating stories was, of course, AIG. On one hand, the insurance subsidiaries of AIG were buying these Residential Mortgage Backed Securities which were offering tantalising yields. On the other hand, another arm of the AIG umbrella – AIG Financial Products – was merrily writing Credit Default Swaps for counterparties. For the uninitiated, in simple terms, Credit Default Swaps (“CDS”) are contracts through which AIGFP sells protection to counterparties in the event the housing market and the corresponding Mortgage Backed Securities and Collateralized Debt Obligations (“CDO”) took the trip down south. Basically, the two units of AIG were taking the same directional bet. So much for risk control! So, in November of 2008, the Fed created Maiden Lane III LLC to alleviate capital and liquidity pressures on AIG. Maiden Lane III LLC borrowed US$24.3bn from the FRBNY and, together with US$5Bn of equity interest from AIG, purchased a portfolio of CDOs from AIGFP’s counterparties. In return, the counterparties agreed to terminate the CDSs that AIGFP had written on this portfolio of CDOs. Subsequently, Maiden Lane III LLC started gradually disposing off the securities in this portfolio through competitive sales processes in the secondary markets. The last of the securities under this portfolio was sold around August of 2012 and the conclusion of this transaction resulted in a net gain to the US tax payer of approx. US$6.6bn, including interest paid on the FRBNY loan.

In aggregate, the 3 Maiden Lane transactions resulted in a net gain of more than US$12bn to the US tax payer. Of course, this is all hindsight. Needless to say, in times of severe crises, the Fed and the Treasury have a larger role to play in terms of maintaining financial stability and preventing an all-out catastrophe scenario where millions of livelihoods could be at stake. At the end though, a pretty decent outcome with a net gain of US$12bn by buying assets at a time when volatility and fear is at its peak and selling them when the storm has passed and the dust has settled. Did we hear anyone say “Buy when the World is Selling”? But then again, reminding you just for good measure, don’t confuse yourself with the Fed. You have no Section 13(3)…

Happy investing!

To know more about Mortgage Backed Securities and the size, scope and nuances of this market, take our Fixed Income Analysis course and watch the video at the link below!

Mortgage Backed Securities – The Credit Balance

Rates at the long end of the Treasury curve have been in sharp focus since the start of 2021. Yields on these risk free assets underpin the valuation of risky assets like stocks. The inflation debate rages on globally. Undoubtedly, inflation has been conspicuously absent in the last decade despite the low interest rate regimes and unconventional monetary policies that have dominated the US and Global landscape since 2009. However, what is different this time around is the global massive fiscal thrust that was significantly smaller in the last crisis. To put things simply, consider the 2 following points –

First, in the US context post the GFC shock, the first major legislation for economic stimulus to be passed by Congress was the American Recovery and Reinvestment Act which was estimated to cost approx. US$800bn. In contrast, so far the 2 major legislations to have passed Congress are the CARES Act estimated at ~US$2Tn and the American Rescue Plan Act of 2021 at ~US$1.9Tn. Add to these, the likely legislations that are in the works and might be passed to provide additional fiscal stimuli – The American Jobs Plan at ~US$2.0Tn and The American Families Plan at ~1.5Tn. Admittedly, the final shape of these plans would be radically different as it passes through the chambers of Congress. Nonetheless, the scale of fiscal firepower deployed in this crisis is enormous. The below chart shows the fiscal deficit in 2009 vs that in 2020. (and 2021 yet to appear on the chart…)

Second, in Europe’s context, the potential upcoming EUR750bn common debt facility is unprecedented – to state the obvious – and potentially a game changer. It has taken a pandemic of gigantic proportions for the EU to finally band together in a marked response of cross border solidarity and take major steps towards fiscal coordination, if not fiscal union. Without a doubt, it is still a long way away and the pathway is littered with challenges before the money starts rolling in. Yet, it is large, it is unprecedented and it is something to not lose sight of.

The fiscal bazookas in this crisis, compared to the past crises, have hence been colossal. Yet, this article is not about the global inflation debate. To get into that debate, I always need to wield the sword of long term structural trends in productivity gains on account of technological improvement. But the above description of fiscal deployment sets the stage for the main point of this article. And that is, apart from inflation expectations, what are the factors to take into account to form a view on the future movement of Treasury Bond rates.

To start with, let us understand the ownership of US Treasuries. Foreign holders are said to account for about one third of all outstanding marketable US Treasury securities. Japan and China are the largest holders at approx. US$1.3Tn and US$1.1Tn respectively. And hence, shifts in demand for Treasuries from these foreign holders creates significant ripples in both the primary and secondary market for Treasuries. Let’s look at some recent data to understand this better. The below chart shows the 10 Year Treasury Yield since the start of 2021. The 10 Year Yield rose almost 75 basis points in the 2 months of Feb and Mar from about 1.0% to 1.75%.

The Japan Ministry of Finance releases data on its International Transactions in Securities every week, based on reports from the major investors in Japan. The below chart shows the net transactions during the months of Feb and Mar 2021. (Negative denotes net disposal of securities). In just the 2 weeks of February 2021, Japanese investors were net sellers of approx. US$30bn of foreign long term debt securities, predominantly US Treasuries. Due to their significance in the demand equation for US Treasuries, this was quite a body blow and yields spiked significantly. Add to this, the weak Treasury auction for the 7 Year Treasury note on 25th of Feb 2021. Lastly, one of the other critical factors probably, was primary dealers offloading Treasuries as well in anticipation of the SLR exemption being scrapped on 31st March 2021.

You have to remember that a 30 year JGB yields approx.. 0.6% which makes the US bond yield extremely attractive even on a hedged basis. Hence, every time US Treasury yields go up, the hedged yield becomes incrementally attractive for the Japanese insurance companies and pension funds. In April 2021, Japanese investors were net buyers of foreign long term debt securities for JPY1,423bn or approx.. US$13Bn. The Japanese insurance companies and pension funds are hence a key player in the US Treasury market and their investment trends need to be constantly monitored.

The second major buyer of US Treasuries is local pension funds, especially defined benefit plan funds. It is no secret that US Treasuries form a core part of their investment portfolios. Their mandate is simply to match the plan’s assets and investments with the expected future liabilities and US Treasuries are the safest ways of doing so. As rates rise, long dated treasuries become incrementally attractive to these funds who are then inclined to rotate back from equities into US Treasuries, providing vital support to investor demand for long dated Treasuries. Usually, pension funds favour buying Treasury STRIPS. For the uninitiated, STRIPS are essentially Treasury Notes or Bonds stripped from their coupons and converted into multiple zero coupon instruments that have a fixed maturity date. These instruments are best suited for the liability matching requirements of pension funds. The US Treasury (or more specifically the Treasury Direct website link provided below) provides monthly reports listing the total amount of outstanding and this is another data point worth monitoring. Any large increase in STRIPS outstanding indicates higher pension fund demand.

www.treasurydirect.gov

Lastly, and most importantly, there is always the elephant in the room – The Fed – who might just come up with more tricks up their sleeve in the form of stirring jargon like Yield Curve Control or Operation Twist, in order to damp down yields on long dated treasuries.

I emphasize again that I do not intend to transform this article this into a debate on inflation vs disinflation or deflation. But if you are betting against the long end of the Treasury curve, you just need to be watchful of all the players on the table and the potential cards they might be holding.

Good luck to Dr. Burry and of course to all of us as well!

Happy investing!

To learn more about US Treasuries, take our Fixed Income Analysis course and watch the video at the below link!

The US Treasury Market – The Credit Balance

The British Pound is probably the oldest existing currency of the world. Here is an interesting fun fact – The English expression “spend a penny” means going to the bathroom, and it originated from the need to pay one penny for the use of a public WC! The United Kingdom has been and still is, no small country. It is one of the world’s most powerful nations and arguably the closest ally of the United States. The British Pound is a major currency and ranks 4th in the list of share of national currencies in Global Reserves. The UK has a long standing, well developed equity market with a total market capitalization of approx. $3.9Trillion (May 2021).

The UK is making its way out of the 2020 pandemic. Vaccinations have been progressing well and the economy is gradually opening up. Should you then consider investing or allocating a part of your portfolio towards UK equities? For instance, the Vanguard FTSE 250 UCITS ETF “VMID” provides a more “domestic” exposure to the United Kingdom by investing in 250 mid-sized companies in the UK. Once again, as an international investor, currency risk is especially important. What is the outlook for the British Pound? This article aims to arm you with some of the necessary data points and considerations for evaluating an investment in a British Pound denominated asset, especially UK equities.

Modern day governments are highly indebted. And the UK ranks amongst one of the top substantially levered nations in the world. World opinion is divided right down the line on the topic of whether public debt and deficits matter in today’s world. But if they indeed do, the UK, with its Public Debt amounting to approx. 100% of GDP, is in an unenviable position on the debt ranking list!

When we start conversing on the topic of high government debt, whether in the case of the UK or any other country, the first commonly heard response is – “Look at Japan”! Japan has, historically had a high Public Debt to GDP ratio because of years of fiscal deficits and it has not affected Japan adversely. But hold on ! There are some key differences. Let us summarize those differences in the simplest of words.

Firstly, and most importantly, a large part of the government’s debt in Japan is held domestically. i.e. by its residents. In contrast, 25% of UK government debt is held by foreign residents. In short, the UK is more dependent on the whims of foreign investors and their view of the performance of the UK economy, the credit worthiness of the UK government and the outlook and stability of the British Pound. Just digressing a bit – Interestingly, the percentage of overseas buyers of JGBs has been increasing as well – from 8.5% in September 2008 pre-crisis to 13% now. And that is a very important point. But we leave it for another day and another post on Japan’s ageing population.

Second, historically, Japan is a nation of savers. While household savings in Japan have reduced over the years, the savings rate is still much higher compared to that of the UK. Below chart shows the Savings Rate comparison between the UK and Japan since the start of this century. Savings rate, in this data chart, is equal to the difference between disposable income (including pension entitlements) and final consumption expenditure.

Corporate savings is another integral component of savings picture in Japan. On the whole, at the broader economy level, domestic savings is much larger in Japan as compared to the UK. The below chart shows a comparison of Gross Domestic Saving as a % of GDP between Japan and the UK.

Lastly, Japan’s net international investment position and current account dynamics vary widely with that of the UK. Explaining the paradox of Japan’s high public debt to GDP and yet its net creditor position to the rest of the world is probably a You Tuber Economist’s favourite topic. In summary, even with the large public debt that the Japan government owes, the nation is still a net creditor to the rest of the world. The below 2 charts reflect the comparison between Japan and UK’s net international investment position and its recent current account history.

Lastly, Japan’s net international investment position and current account dynamics vary widely with that of the UK. Explaining the paradox of Japan’s high public debt to GDP and yet its net creditor position to the rest of the world is probably a You Tuber Economist’s favourite topic. In summary, even with the large public debt that the Japan government owes, the nation is still a net creditor to the rest of the world. The below 2 charts reflect the comparison between Japan and UK’s net international investment position and its recent current account history.

Long story short, the difference in macro-economic factors for the UK and Japan are as radically different as the culinary treatment a salmon would receive between becoming a pan fried fillet and being served on a sashimi platter.

However, coming back to the topic of the investment case for the UK and the British Pound, I go back to the points I mentioned at the start of the article. The UK is still a major economy, a 2 trillion pound GDP powerhouse and well rated (AA / Aa2). UK gilts are still sought after by foreign investors, more importantly central banks worldwide and large private investors like the Japanese pension funds. The UK, in the last 5 years, has witnessed a fair amount of tumult on account of the Brexit decision, fears of a hard exit, public finance challenges, the constant threat of a Scottish referendum, etc. However, there have been some fortunate tailwinds in the recent past. Most important of those being a superb roll out of vaccination throughout the country and a fairly cordial and soft exit out of the EU with some trade issues and agreements satisfactorily settled. Let us then further list down some of the key aspects to consider and key data points to watch out for in the near term to supplement the case for investment into a UK asset.

1. Monitor the Current Account Trends

Needless to say, the UK has been increasingly dependent on foreign investors to buy UK gilts and fund its balance of payments shortfall. The current account deficit needs to be monitored carefully and signs of increasing deficit might just set the cat amongst the pigeons as far as overseas investors of UK gilts are concerned.

2. Exports to the EU

The key data point to monitor, in order to stay informed on the current account deficit trends for the UK, is exports to the EU. With the risk of a No-Deal Brexit now behind us, the key test for the UK is whether it is able to keep up its exports or in fact, be able to grow its exports to the EU. March data was encouraging (shown in red below). Services exports will be key and there are still significant questions unanswered about the impact on the London financial services industry on account of Brexit.

3. Performance of UK Gilt Auctions

The demand for UK Gilts has remained resilient throughout this crisis. With an increasingly positive vaccination outcome and the risks of a No-Deal Brexit having subsided, the outlook for the demand for UK Gilts continues to remain favourable. In April 2021, the sale of a 30 year Gilt was fairly successful amongst heavy investor demand.

4. Early Tapering by BoE

The Bank of England recently announced that it was slowing down the pace of its bond purchases. But it stressed that it is not reducing the total size of its QE. The market could perceive this as some form of tapering and with US and Europe still well into an expansionary stance, the latest BoE move augurs well for UK Gilts and the British Pound.

5. Projected Fiscal Deficit and Actual Borrowing

To top it up, the latest releases from the UK Debt Management Office suggest that the net borrowing for FY 2021-22 might be lower than previously anticipated (from approx. GBP290bn to GBP250bn). In simple words, this means a further curtailed supply of UK Gilts, which might be viewed favourably by the markets.

In summary, the UK looks well positioned compared to a lot of the other countries, given recent tailwinds. Lastly, even from an valuation perspective, UK equities look cheaper compared to more lofty US equity valuations. (The FTSE 250 index is trading at approx. 15.0x PE – Data Source : Vanguard FTSE 250 UCITS ETF “VMID” as of 17 May 2021).

Key risks to monitor, as explained above:

• Underperformance of UK Gilt auctions
• Falling exports especially to the EU in the coming few months and a worsening current account deficit situation
• An unexpected surge in Covid cases (and probably the most important one to monitor! Cases have already multiplied in the last 2 weeks)
• Increase in political instability, Scottish referendum anyone?

Happy investing!

There have been some interesting developments in the Index Linked Gilts market in the UK. To know more about these developments and understand UK Linkers, take our Fixed Income Analysis course and watch the video at the link below!

UK Inflation Linked Gilts – The Credit Balance

Footnotes:
Data on Reserve Currencies

The developments around replacement of Libor and the evolution of SOFR as an alternative rate have been one of the most important events to follow in global markets in recent times. The SOFR surge event of 17th Sep 2019 (basically there was a significant spike in SOFR on that day attributable to a variety of reasons that has been adequately written about. See image below) raised questions about whether the markets and regulators have sufficiently thought through the appropriateness of SOFR as a benchmark to replace the all-important Libor (Fun fact: Libor said to linked to $400 trillion of wholesale and consumer global transactions!)

There might be another event quietly taking place right now, which in some sense can be said to be the other end of the spectrum on which the SOFR Surge event lies. Typically, short term rates are squarely in the domain of the Fed and there has been some evident pressure in the short term rates space since the Fed took away the SLR relief granted to Banks on the last day of March 2021. Below are 2 charts / images which illustrate the pressures on short term rates. While the Fed wants to steer clear of negative rates, (given the patchy track record of negative rates in Europe and Japan), the overnight rates in some quarters are being transacted at negative levels nonetheless.

The first graph shows the dollar quantum of transactions being transacted at the Reverse Repo window at the Fed (area marked in Red). The sheer amount of liquidity which basically has no other place to be parked at gets routed to the Reverse Repo window at the Fed. These are essentially transacted at 0%.

The second image shows the consistency with which some of the overnight secured transactions are being dealt in negative territory.

I would not profess to be an expert at monetary policy and rate transmission effects. However, this is a worthwhile corner of the market to keep track of. The long end of the rates curve is subject to the vagaries of the bond market. Does the Fed have adequate control of the short end? Investors should keep an eye on the developments in short term rates and monitor the above mentioned 2 data points.

Happy investing!

To learn more about US Treasury ETFs that invest in the shorter end of the interest rate curve, take our Fixed Income Analysis course and watch the video at the below link!

The US Treasury ETFs – The Credit Balance

Materials worth reading

Policy recommendations for enhancing the liquidity of the US Treasury markets
Senator Elizabeth Warren’s letter to the Fed on the SLR relaxation
A simple explanation of what is the Repo Market

US Interest Rates (i.e. Treasury yields in the US) are always a key determinant of asset prices, especially equities. And in today’s context, it is probably more important than ever. Hence, it is vital to keep a close eye on developments within the US Treasury markets. While the secondary market for US Treasuries and yield levels in the secondary market are easy to keep track of (Simply looking at the various sources online, like Bloomberg or FT, to watch the 10 year Treasury yield or the 3 month Treasury Bill yield), keeping track of developments in the primary market for Treasuries offers even better insights for investors. In the space below, we provide a quick summary of where to look and what to look for in the primary market for US Treasuries.

U.S. Treasury marketable securities are debt instruments issued to raise money needed to operate the federal government and pay off maturing obligations. These securities are sold to institutional and individual investors through public auctions. Treasury auctions occur regularly and have a set schedule. There are three steps to an auction: announcement of the auction, bidding, and issuance of the purchased securities.

www.treasurydirect.govs is the website to understand Treasury auctions and more importantly, to track auction results.

www.treasurydirect.gov The website will generally provide a tentative schedule of Treasury Securities auctions and will release the auction results at around 1.00 to 1.30pm Eastern time on the day of the auction.

Lets have a look at a recent Treasury auction result to understand how to read the auction result release and the key points to watch out for. The below is the auction result for the 7 Year Note conducted on 25th of Feb 2021. There are 3 key data points to look out for are –

• The High Yield or the Stop out Yield
• Demand from Real Money vs Primary Dealers in the Auction
• The Bid to Cover Ratio

This particular auction had resulted in a less-than-ideal result and, as you can see from the chart below, Treasuries, in general, fell significantly in response to the poor auction result. (i.e. yield climbed).

The High Yield or the Stop out Yield

The High Yield or the Stop out is the highest yield at which the auction clears. As you know, Treasury auctions are conducted as Uniform Price Auctions. i.e. all the successful bidders in the auction pay the same price. In other words, they all get the same yield. This is the maximum cost (yield) that the Issuer (in this case the US government) has to bear in order to successfully complete the auction and sell the full amount of treasury securities that were intended to be sold in the auction. If this High Yield was significantly above the “When Issued” market yield on that Treasury security, then the auction performance has been less-than-ideal. The “When Issued” yield is basically the yield on the Treasury security just before the auction bidding deadline. Admittedly, for a retail investor, without access to sophisticated real time trading information, it is difficult to assess whether the high yield was significantly above the “When Issued” yield (also called a long “tail”). Nonetheless, the High Yield offers good insight into the pricing and demand for the Treasury security in the auction. In the below image, you can see that the High Yield in the 7 Year Note auction was 1.195%.

Demand from Real Money vs Primary Dealers in the Auction

The result release includes a breakdown of buyers in the auction – broken down into 3 categories – Primary Dealers, Direct Bidders and Indirect Bidders. Indirect Bidders are essentially bidders that bid for the auction via an intermediary. These include key buyers in a Treasury auction like foreign and international monetary authorities. Direct Bidders are essentially non-primary dealer financial institutions that bid directly on the auction i.e. not via an intermediary. These include pension funds, hedge funds, insurers, banks, governments and individuals. Hence, Direct and Indirect Bidders are seen as “real demand” accounts in the auction. Primary Dealers, on the other hand, are mandatorily required to bid in auctions and hence a larger allocation to Primary Dealers is generally seen as an indicator of weak demand. On the other hand, a higher allocation to Direct and Indirect Bidders is seen as a positive result in the auction. In the below image, you can see that the bid quantum and the accepted quantum for Indirect Bidders is the same which indicated weak “real” demand in the auction.

The Bid to Cover Ratio

Lastly and most importantly, the Bid to Cover Ratio is seen as the headline indicator of the Treasury auction performance and usually is the main metric reported in financial media. It is calculated as Total Tendered Bids divided by Total Accepted Bids. A lower than recent average ratio is perceived to be very negative. In this auction, the Bid to Cover ratio was 2.04 which was fairly below recent averages in the Treasury note auctions and hence perceived very negatively by the market.

Hope this helps you read treasury auction results release better and keep your fingers on the pulse of the US treasury market.

Happy Investing!

To learn how a Uniform Price Auction works, together with a numerical example, take our Fixed Income Analysis course and watch the video at the below link!

Uniform Price Auction for US Treasuries – The Credit Balance

All that glitters is not Gold. Unless of course you are referring to GDX, GLD or other similar ETFs! Gold and Gold ETFs have had a phenomenal run since the last couple of years. Through this article, let us look at some of the key factors that can explain gold price performance.

Firstly, you have to look at Gold in its historical context. While from an application perspective it has fairly limited real use cases, historically Gold has been treated as Money for centuries together and regarded as “Store of Value”. In contrast and by comparison, the true fiat currency world has been in play just the last 55 years or so, post abandonment of the Bretton Woods system. That “store of value” belief has remained deep rooted and is not going away.

When I evaluate Gold as an investment asset class, I primarily narrow down my focus to 4 main factors – the direction of real interest rates, demand for physical gold, relative strength or weakness in the US dollar and state of the equity markets.

Real Interest Rates: Gold price movement can be largely explained by its extremely strong negative correlation to real interest rates (See Graph below). US monetary policy is expected to be accommodative for a long period of time from now. While there are significant risks of deflation, there are also significant inflationary pressures from factors like the unprecedented large fiscal measures taken by almost every country (whether they can afford it or not from a budget financing viewpoint!), supply side constraints and international trade tensions and related re-shoring activities. On the other hand it is worth noting that even if the deflationary pressures start building further, the Fed and the US government seems ready to “Do whatever it takes” which will keep real interest rates low for the foreseeable future. On a separate note, whether this unprecedented US fiscal spend will result in an unsustainable US debt level and result in paradigm shift in the global financial system is anybody’s guess and topic of discussion for another day.

Relative Dollar Strength / Weakness: After the initial flight to safety in late March 2020, there was a continued weakness in the US Dollar attributable to multiple factors including, loose monetary policy and also a general view that the world seemed to be doing better than the US in dealing with the virus situation. A weak dollar augurs well for Gold since it makes buying Gold more affordable. (See graph below. Alternatively look at DXY on Bloomberg for the below period). Interestingly a major risk event in the Rest of the World, geopolitical escalation in the Middle East, usually results in dollar appreciation – mostly on account of flight-to-safety. As an example – if one looks at the August 2011 to August 2012 period, real interest rates were declining and yet Gold price scaled back from an all-time high of around $1,900 to approx. $1,550. The dollar was in a broad based strengthening phase given the severe public debt crisis in Europe.

Physical Demand: Just like any other commodity, physical demand for gold also plays a large role in the determination of its price. Around 50% of demand for physical gold comes from Jewellery consumption and Central Banks constitute another 11% (Source World Gold Council). Again, a weaker US dollar makes it relatively more affordable for consumers in India and China, which are the 2 biggest countries of consumer demand for physical gold. Once again, adding shine to its investment value and store of value proposition, is the deep rooted cultural significance and resulting attractiveness for Gold purchases in India. India imports approx. 750-800 tonnes of Gold every year. Admittedly compared to China, the Indian economy is probably going to be hit harder and that will reduce consumption demand. Central Banks have been increasing their share of gold reserves in the past decade. Currently Central Banks and supra-national organizations are said to hold approximately 34,000 tonnes as Reserve Assets. Demand from the Central Banks has expanded rapidly since the Great Recession of 2009, especially large scale purchases by Central Banks of Emerging Market and Developing Economies. The long term rationale seems quite simple – heightened geopolitical and economic risks including the prominence of China as a competing power to a hitherto unipolar world and resulting risks to the dollar, unprecedented debt binge by the supposed leading economies of the world and resulting uncertainty in the world economic order and monetary financial system. This trend seems unlikely to reverse. According to official reports China’s official gold reserves are said to total approx. 1900 tonnes, almost triple pre-2008.

State of the Equity Markets: Lastly, the state (or the outlook) of the equity markets play a strong role in the direction and quantum of gold price change. While the world is awash with liquidity, at the end of the day all asset classes have to compete for investor wallet share. As equity starts performing better (which typically happens when risk levels off), investors start to rebalance portfolios and tend to rotate out of gold and into equities. For instance, looking back at the post Financial Crisis period, it was really post 2013 that a secular equity rally took hold and continued up till 2017-18. During this period gold generally underperformed.

To recap, Real interest rates, Relative dollar strength or weakness, retail demand and central bank demand and finally the state of the equity markets are the key determinants of Gold price performance. There is a definite role that Gold plays in strategic asset allocation and a well diversified portfolio. Each of the above factors need to be monitored constantly to though, to do tactical allocation shifts in and out of Gold.

Happy investing!

The Bond Markets have been solidly in the news lately. All eyes are on the Treasury Notes and Bonds space to see where yields are headed and what is the Bond Market’s take on projected inflation. With so much happening in the Treasury bond markets right now, it is an opportune time to know and understand some of the alternatives available for fixed income investors in the ETF space.

Here are some Treasury ETFs for your consideration.

SHY

SHY or the iShares 1-3 Year Treasury Bond ETF (which has also been explained in the Treasury ETF Lecture) remains one of the largest and most popular Treasury ETFs with approx.. US$20bn in Net Assets as of March 22, 2021. However, given how low short term interest rates are today, the yield from investing on short tenor Treasury Bonds is next to nothing. Current YTM on the underlying Treasury Bond portfolio is approx. 19 basis points (or 0.19%). Last 12 months trailing yield was 70 basis points as of Mar 22, 2021. Management fee itself is 15 basis points.

If you look at the historical performance, you can see that the ETF performs really well when short term interest rates are on a downward trend. Remember Bond Prices move in opposite direction to Interest Rates! As the Fed started cutting rates from the end of 2018, SHY NAV increased in response to the rate cuts. When the Fed cut rates further in response to the Corona Virus pandemic in Feb and Mar 2020, the NAV rose even further to a high of almost US$87. (See Area marked in Red below)

One of the key points to note though is that the ETF is highly liquid. Average daily volume is almost 3mn shares. Given the highly safe nature of the underlying securities (i.e. short dated US Treasuries) and the ample liquidity in the ETF, bid-ask spreads are very low – approx. 1 basis point. In summary, this is the safest asset class one can invest in. The yield may be paltry, but you are assured that you investment is ultra safe – both from credit risk and interest rate risk.

VGSH

Similar to SHY, VGSH or Vanguard Short Term Treasury ETF is also an ETF that primarily invests in short dated US Treasury Bonds, typically tenor of 1 – 3 years. The VGSH is also a large and popular ETF with net assets of approx. US$10bn as of 28 Feb 2021. Current YTM on the underlying portfolio is also 20 basis points, similar to SHY. However, one of the most important and key differences between the 2 ETFs is the management fees. VGSH has an expense ratio of 5 basis points compared to the 15 basis points of SHY. This can be highly significant especially when interest rates are so low and yield are negligible. You can see the 30 day SEC yield (a SEC mandated standard metric useful for comparing funds) is 4 basis points for SHY and 11 basis points for VGSH (Data as of 23 Mar 2021).

Once again, similar to SHY, you can see that since the ETF is essentially an exposure to short dated US Treasuries, the NAV climbs higher when short term rates are trending down.

TLT

Lets switch gears and look at some long tenor bond ETFs. TLT or the iShares 20+ Year Treasury Bond ETF is amongst the largest ETFs that cater to the long end of the Treasury curve. Key points –

Net Assets = US$14.7Bn
Avg. YTM = 2.42%
Effective Duration = 18.43 Years
Fees = 15 basis points
12 month Trailing Yield = 1.66%
(Data as of 23 Mar 2021)

Here is a quick look at the last 10 year NAV history chart. As you can see the ETF NAV has almost doubled over the past 10 years. Fixed Income has had a phenomenal bull run over the last few decades on the back of ever reducing interest rates. Decades of unconventional monetary policy across the globe has created an endless demand for US Treasuries. And most importantly inflation has noticeably been absent causing many to question the success of this monetary policy. However, what has been transpiring over the last few months in the bond markets is intriguing. The yield of the 10 Year US Treasury has increased from 0.9% to 1.65% in the first 3 months of 2021. Notice the area marked in red in the chart below. The TLT ETF price has fallen from a high of US$171 to $136 (as of March end 2021). Due to the high Duration, the ETF is highly sensitive to changes in interest rates and inflation expectations. The question to ponder upon is when does the Fed start getting uncomfortable with the rise in the longer end of the rate curve. Till the economy and more importantly the capital markets show no sign of distress from the rising rates, the Fed will choose to stay neutral. But when things get a little out of hand, will the Fed increase its monetary easing measures and start buying more long tenor Treasury Bonds and press down yields as a part of its Open Market Operations?

Happy Investing!

To know more about the US Treasury market, it size and scope, nuances, analysis of Treasury securities ownership and many such interesting topics, take our Fixed Income Analysis course and watch the video at the below link!

The US Treasury Market – The Credit Balance

One of the most interesting developments in the Global Fixed Income space has been the rising prominence of the China Bond Market onto the world stage.

Firstly, the China Bond market is a relatively nascent one. (Fun fact – The first Chinese government bond was issued as recently as 1981). Secondly, this market has traditionally been always closed to foreign investors. And for good reason. China has always adopted a cautious approach to the inflow of foreign money. And as good economics would suggest, it has prioritized longer term investment alternatives like FDI over hot money alternatives like short term bond investments. However, as China takes a more prominent role in World politics and the gradual ascent towards establishing RMB as the global reserve currency alternative, liberalization of the foreign exchange market and internationalization of its Bond market are critical milestones to achieve.

The total China Bond market, by some estimates at $13Tn, is now second largest in the world, behind the US and having overtaken Japan. Yet, it is predominantly a domestic only market with minimal foreign investor participation. Make no mistake – the foreign investor participation is growing significantly. But nonetheless still comprises a small portion of the total investable bond market. Estimates suggest foreign investors hold approximately 3-5% of the total market size. The onshore market is dominated by Commercial Banks. Approximately two thirds of the bonds outstanding are said to be held by the Commercial Banks. Digressing to a macro note, this means that the economy is still dependent on the strength of the Banking sector and the desired level of dependence on and resilience of the capital markets is still some distance away.

Historically Investors have shied away from this market for the most well-known of reasons, a tough approval regime, investment quotas, difficulty of repatriating profits and accessing the onshore China Fx market to hedge the bond investment exposures. The first change came in July of 2015 when PBOC allowed foreign official institutions to directly access the China Inter-bank Bond Market (“CIBM”). Subsequently in Feb 2016, the PBOC started allowing “recognized” long term institutional investors to access the CIBM. Lastly in July 2017, China officially launched the much awaited Bond Connect program.

Yet, the most significant development in this space has been the inclusion or upcoming inclusion of China Bonds into the most popular and vastly tracked Global Bond Indexes. The first to go live was Bloomberg Barclays Global Aggregate Index. In January 2019, Bloomberg announced that Chinese RMB denominated government and policy bank securities will be added to the Index starting April 2019. Needless to say, the actual inclusion into the Index will be phased in, but when completed, Bloomberg anticipates it to be the 4th largest component in the Aggregate after USD, EUR and Japanese Yen. Anticipated to have a weight of 6% of an approx. $54 Trillion Index! Not all of the funds tracking the Index will pursue or have the mandate to invest in China Bonds. There will be alternative indexes created within this Category that exclude the Chinese Bonds. Yet, it is estimated that about $300-400Bn of investments will start flowing into the China Bond market with its inclusion in the Bloomberg Barclays Global Aggregate Index as well as FTSE World Government Bond Index and and JPM Government Bond Index – Emerging Markets.

There are some compelling arguments for the case of investing in the China Bond Market. Firstly, in a world where almost $17Tn market value worth of debt is negative yielding, the 2.5% – 3% that China government securities offer looks stellar in comparison. Add the fact that this is A/A+ rated the return looks even more appealing on a risk adjusted basis. Secondly, there have been enough number of studies which have shown negative correlations between Chinese bonds and global equities.

Let’s look and compare some of the alternatives to invest in the China bond market – both government and quasi-government as well as the corporate space. Below is a table summarizing some of the open-ended Mutual Fund investment alternatives that provides exposure to the China Fixed income space.

	Blackrock China Bond Fund	Fidelity China Bond Fund (3)	JPM China Bond Opportunities (4)	Neuberger Berman China Bond Fund
AUM	$4.4Bn	$254mn	$62mn	$137mn
YTM	5.04	NA	5.04%	7.9%
Mod. Duration / Time to Maturity	3.98 Yrs	NA	3.4 Yrs	1.77 Yrs
Mgmt Fee	0.75%	0.75%	1.0%	1.3%
Inception	Nov 2011	NA	Jan 2020	NA
Dist. Class Available	Yes	No	Yes	Yes
Currency Class Available	Yes	Yes	Yes	Yes
Annualized Return since inception	5.58%	3.86%	4.4%

1. Fund AUM, YTM, Duration figures are as of around end October / November 2020 for all the funds
2. The fund returns are on an NAV to NAV basis assuming reinvestment of dividends and after factoring in management fee / expenses
3. Fidelity Fund includes exposure to other EM. 62% geographic exposure to China as of 31 Oct 2020
4. JPM Fund also includes exposure to other EM, not just China.

The Neuberger Berman China Bond fund, in particular, is specifically focused on the China corporate bond sector with minimal exposure to govt or govt policy banks. Approx.72% is invested in onshore Chinese bonds and 27% is invested in offshore Chinese bonds with almost half being BB rated.

In line with the proliferation of passive investment strategies and the ETF boom, the China Fixed Income space has also started seeing its share of ETFs. Below are some of the alternatives that currently are available to investors, especially for the China government and policy bank bonds.

	ICBC CSOP Chinese Govt Bond Index ETF	Nikko AM ICBC SG China Bond ETF	iShares China CNY Bond UCITS ETF	Harvest China Government Bond UCITS ETF	Goldman Sachs Access China Govt Bond UCITS ETF
Fund Size	$1.06Bn	$187mn	$5.5Bn	$100mn	USD111mn
Fund Inception Date	Sep 2020	Nov 2020	Jul 2019	Jul 2015	Oct 2019
Listed on	SGX	SGX	LSE	LSE	LSE
Exchange Ticker	CYC	ZHY	CNYB	CGB	CBND
Listing Date	Sep 2020	Nov 2020	26 Oct 2020	Jul 2015	Oct 2019
Underlying Index	FTSE Chinese Govt Bond Index	China Bond ICBC 1-10 Yr Treasury and Policy Bank Index	Bloomberg Barclays China Treasury + Policy Bank Index	CSI Gilt Edged Medium Term Treasury Bond Index	FTSE Goldman Sachs China Govt Bond Index
Base Currency	RMB	RMB	USD	RMB	USD
Listed Currencies Available	USD, SGD	SGD	USD	USD	USD
Mgmt Fee / Expense Ratio	0.25%	0.3%	0.35%	0.4%	0.35%
Effective Duration	5.64	4.0 Yrs	5.61	5.03	5.6
Weighted Avg Maturity	7.5 Yrs	NA	7.5 Yrs	NA	7.5 Yrs
YTM	3.18%	3.23%	3.34%	2.99%	3.2%
Dist. Class Available	Yes	Yes	Yes	Yes	Yes
Dist. Frequency	Semi-annual	Semi-annual	Semi-annual	NA	Semi-annual
Annualized Return since inception	NA	NA	6.48%	1.35%	8.0%
Fund Domicile	Singapore	Singapore	Ireland	Luxembourg	Ireland

Both the ICBC and Nikko AM ETFs are relatively new having established the fund and commenced trading in late 2020. Both are domiciled in Singapore – a testament to Singapore’s efforts to attract more fund management industry participants to set shop in the country and to be a prime destination for funds to entice global investors. The ICBC CSOP ETF in particular has quite a sizeable fund size at inception. As the attractiveness and acceptance of Chinese bonds grows amongst the international investor community, these ETFs are well poised to increase assets under management.

Happy Investing!