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.
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.
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!
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.