China bonds: then, now and in the future
It may be counterintuitive but Chinese bonds are actually an intriguing trade war hedge investment
AS China’s domestic bond market unlocks, it is gradually winning recognition from global bond investors for good reason – its potential positive returns stand out in a world awash in negative yielding debt. Yet a range of concerns hold back some investors, whether it be worries about market liquidity, hedging options or China’s yuan currency itself.
We believe that having the context and knowledge to grasp the unique drivers underlying China’s rapidly maturing bond market will ultimately dictate investors’ ability to capture returns. This US$13 trillion market might seem at first glance like a homogenous behemoth, but in reality, it’s a complex ecosystem made up of different underlying sub-sectors, with fundamentally different dynamics underpinning asset performance.
It is therefore critical to have insight on how the mechanics of this nuanced market work together in order to navigate it successfully.
Lifting the lid on the China bond market’s three sub-sectors
As a quick asset class primer, China bonds aren’t denominated only in renminbi (RMB). Instead, it is represented by three segments: an onshore RMB-denominated bond market (CNY) and two offshore bond markets, one denominated in RMB (CNH) and the other in US dollars (USD).
The return drivers are dissimilar for the underlying markets, creating interesting investment opportunities for those able to allocate across the sub-sectors in order to capitalize on the differences.
The onshore RMB bond market is typically of highest interest due to recent index inclusions. It is the largest bond market in Asia ex-Japan with high sensitivity to PBOC’s monetary guidance. In comparison to onshore, the offshore RMB bond market is the smallest market within China bonds and tends to have sensitivity to CNH HIBOR rates. Lastly, the USD China bond market is primarily comprised of corporate bonds and trades based on a spread plus US Treasury rates.
As the return profiles tend to vary significantly between the three sub-sectors over the longer term, it is important to take an active investment approach to pick through the opportunities. Such an approach can capitalize on differences between the markets and achieve valuable diversification by holding a balanced exposure.
Beyond asset allocation, there are also opportunities for cross-market arbitrage between sub-sectors of the China bond market. There are cases where the same Chinese issuer could have outstanding bonds in the CNY, CNH and USD markets, and thus these bonds may have different yield prospects, allowing for yield maximization or arbitrage.
China’ bond markets may offer (surprisingly) positive return prospects
A grasp of the unique dynamics at play and the wide range of secular return drivers underpinning the China bond market adds a degree of perspective for global investors who might be tempted to dismiss holding China bonds altogether due to ongoing trade tensions or renminbi depreciation.
The reality is that for managers with the breadth and depth to navigate these sub-sectors, there are interesting positive return opportunities despite the macro uncertainties.
Indeed, China bonds have delivered positive total returns despite some RMB currency pressures this year and the market as a whole has generated positive total returns in USD.
Having outlined the keys to steering through the China bond market ecosystem and the seemingly counterintuitive fact that Chinese bonds are actually an intriguing trade war hedge investment, it makes sense to look ahead at China bond market return prospects in 2020.
Looking at 2020
This year  has shaped up to be a strong year for China bonds and other fixed income markets, and it’s looking like similar opportunities could be had in 2020.
For most fixed income asset classes, the 2020 outlook is heavily dependent on the pace of the US-China trade negotiations, and the US elections. Today, global bond yields have gone lower (prices have gone higher) compared with the start of 2019. With the increasing chance that the US and China may sign an initial trade deal, some pressures may even emerge on yields and USD. In a yield starved world, generating income will continue to be paramount for investors next year, but currencies could also present interesting investment opportunities.
The RMB, as measured on a trade-weighted basis, has become relatively attractive with the trade uncertainty. Should a trade truce be reached, it could spur RMB appreciation, thus benefitting investors holding Chinese bonds as well as offsetting some of the rates sell-off.
Equally if not more critical, managing duration, or the sensitivity of the bond’s price to changes in yields, as well as seeking sources of alternative duration, will be key determinants of returns. We believe a mix of CNY, CNH and USD bonds could be an attractive diversifier for investors with prospects of decent yield levels and their low correlations to global bond markets. Chinese bonds could be in a sweet spot if a positive trade deal is reached, with the resulting global yields sell-off.
Bringing it all together, as China’s bond market becomes an important pillar of the global financial landscape, investors can no longer stay on the sidelines and be intimidated by the notion of investing in China bonds. In reality, holding exposure to this market is not nearly as courageous as one might think, particularly for managers with the expertise to tap into what is a fertile ground for investment opportunities. That said, the complexities and nuances of the sub-sectors within the China bond market call for a cautious and well-researched approach. Successfully navigating the dynamics of China’s bond market will require in-depth market knowledge and a laser focus on risk-adjusted returns.
Jason Pang is a fixed income portfolio manager at J.P. Morgan Asset Management
20 Nov 2019