China Bonds Are Still Too Big To Ignore>
As China navigates a bumpy economic recovery and investor sentiment appears to be near all-time lows, we wanted to revisit the investment case for continued exposure, specifically from a fixed income perspective. In short, despite current headwinds, we believe China is too big for global bond investors to ignore, and recent headwinds are an example of how its economy stands apart from the rest of the world. Further, the onshore market, which is the second largest globally, is extremely vast and diverse, allowing investors to selectively find exposure that may help strengthen an overall global bond portfolio in the long term.
From a yield perspective, the case for China bonds has undoubtedly become less compelling following a decline of about 100 basis points (bps) since their recent high in 2020. China’s 10-year government bond yield recently hit its lowest level on record, approximately 2.2%. Further, and perhaps more importantly, the yield differential versus the U.S. hit its lowest level as well, with the 10-year bond yielding 2.4% less than its U.S. counterpart. Chinese bond yields are also well below emerging markets peers, which on average yield about 7%, based on the J.P. Morgan GBI-EM Global Diversified Index as of May 10, 2024. To be sure, China’s size and single-A credit rating make a direct comparison challenging, and its global economic standing and resources make it hard to compare against similarly rated countries like Iceland and Israel, but the trend has been clear.
China Bond Yields Have Hit a Bottom, while CNY Has Depreciated
Source: ICE Data Services and JP Morgan, as of 3/31/2024. Yield Pickup is represented by the difference between ICE BofA China Government Index yield and ICE BofA Developed Markets Sovereign Bond Index yield. Past performance is no guarantee of future results.
For bond investors, the yield decline over the past few years has provided significant support to returns while most global markets counterparts have struggled. The FTSE Chinese Government Bond Index returned about 1.9% per year as of April 30, 2024 since Chinese bond yields peaked in November 2020, while G-7 government bonds returned -7.8% annually. These returns include an approximate 9% depreciation of the Chinese renminbi (CNY) versus the U.S. dollar over the period. Although the CNY depreciation is notable for an historically stable currency, the currency did outperform its broader emerging markets currencies in that period.
To be sure, performance in recent years reflects structural challenges in the domestic economy that must be addressed before foreign investors return with confidence. Data has been mixed. A recent upside surprise in manufacturing PMI was promising, albeit not overwhelmingly so, while other data such as credit aggregates continue to be sluggish. Optimism on the policy front, particularly to address real estate sector concerns, and potentially renewed stimulus measures have provided hope for a more sustainable economic growth trajectory going forward, which may help to stoke foreign investor interest once again. We also note that longer term, assuming prudent policies are pursued and stable, robust growth can continue (albeit at lower levels than what was seen in previous decades), bond yields at current levels may be a reflection of China’s economic strength globally and need not rise substantially to justify a role in a diversified global bond portfolio.
Focusing on corporates, we believe there have been some positive trends. First, many troubled issuers (particularly in the real estate sector) have seen substantial declines in value or have defaulted, and therefore been removed from the index. This has resulted in a significantly lower exposure to China within the ICE Diversified High Yield US Emerging Markets Corporate Plus Index: approximately 2.2% as of May 10, 2024 versus nearly 8% four years ago. Credit spreads of onshore bonds have, in general, seen a modest decline over the past two years. With heightened caution by foreign investors following stress in corporate sectors such as real estate and certain financials, we believe reliance on global credit ratings may provide more confidence to invest in onshore corporates. The vast majority of the local corporate market relies on local ratings, which are not comparable to Western credit ratings and can cause confusion.
Although overshadowed by sluggish macroeconomic indicators, we believe the uncorrelated nature of the onshore market to the rest of the world is an important takeaway. It is worth remembering that Chinese bond yields increased following the onset of COVID-19 amid domestic economic resilience while U.S. bond yields plummeted. Over the past decade, the broad onshore Chinese bond market has exhibited a low correlation to the U.S. and global broad markets, as well as other core asset classes, and a lower correlation to these asset classes than the broad EM local currency sovereign bond market.
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