Emerging market investors are betting that a bull run in China’s bond markets has further to go, even as Beijing signals increasing discomfort with a soaring rally in government debt.
China’s central bank has been trying to cool a frenzy for long-term government bonds this year driven by local investors who have pushed yields down to about 2 per cent, a response to faltering consumer demand in the world’s second-biggest economy.
While foreign investors have cut their direct holdings of Chinese government bonds in recent months, they have instead ploughed into short-term debt issued by Chinese banks and used currency trades to boost overall yields to rates above US Treasuries, in US dollar terms.
“From a macro, fundamental perspective, there is still a lot of support for yields to go lower,” said Mark Evans, an analyst in Asian bonds and currencies at asset manager Ninety One. “There is very little inflation in the economy, however you look at it, and that is reflective of weak domestic demand. The real yield on the bonds is pretty attractive.”
Yields on 10-year Chinese sovereign debt have fallen to 2.1 per cent, and those of 30-year paper have hit 2.3 per cent, as worries about deflation have stalked China’s economy following a crisis in the housing market.
On paper, nominal yields that are far below US Treasuries in what is still a largely closed capital market should be warding off overseas buyers. Foreigners own about Rmb2.2tn ($300bn) of Chinese government bonds, about 7 per cent of the total, down from more than 10 per cent three years ago, according to ChinaBond, a securities depository.
But Chinese onshore debt has remained relatively attractive to outside investors who can also earn extra yield from swapping dollars into renminbi, which can be parked in the bonds.
Overseas holdings of these negotiable certificates of deposit issued by Chinese banks surged to more than Rmb1tn as of the end of July, versus about Rmb260bn a year ago, according to Shanghai Clearing House data.
“When you do a forward to hedge your exposure, it is quite an attractive yield pick-up,” at currently about 4 percentage points on an annualised basis, on top of underlying government bond yields, said Sabrina Jacobs, a portfolio manager at Pictet Asset Management. “That gets you in the 6 per cent region, in US dollars, for an asset class that is very uncorrelated to the US market.”
Slightly higher yields and shorter maturities on bank bonds have made them even more attractive for these swaps. Over the past year this debt has made up about two-thirds of the net purchases of Chinese bonds by foreigners, who meanwhile cut government debt to about half of their overall holdings, according to analysts at Citic Securities.
The People’s Bank of China has said it is prepared to intervene in the government bond market for the first time in decades to prevent a sharp fall in long-term yields over concerns that an eventual snapback could trigger Silicon Valley Bank-style losses in the financial system.
“They don’t like one-way expectations and they don’t like herding behaviour, given the financial stability risks,” Evans said.
But some international investors say the central bank’s comments and potential intervention appear targeted at ensuring long-dated bond yields do not fall too much relative to short-term rates, rather than holding back the market as a whole.
The PBoC is focused on preventing an “asset liability mismatch” in smaller lenders, who are buying up long-term bonds to park money from an influx of deposits as households save rather than spend or invest in property, said Liam Spillane, head of emerging market debt at Aviva Investors.
“The central bank is being very transparent in its desire to try and create a bit more two-way risk and volatility in the curve,” he said. “We don’t think they’re trying to push yields higher.”
The overall foreign outflow from China government debt comes despite reforms in recent years that have made it easier for investors outside the mainland to buy such assets.
China has also been accepted into global benchmarks for local-currency emerging-market bonds, although it still has a relatively small weighting compared with its share of world stock indices.
“Unlike equities, where exposure is over 20 per cent, China doesn’t move the needle for emerging markets fixed-income investors,” said Malcolm Dorson, head of emerging markets strategy at Global X ETFs. “There is not much downside to walk away from China bonds right now.”
But because Chinese government bonds have traded out of sync with other global debt markets in recent years, they have delivered decent returns, whether in renminbi or hedged into other currencies, Jacobs said.
Ultimately, investors are expecting Chinese banks and other domestic investors to keep having to buy government bonds in place of lending to a slowing economy with few measures on the horizon to lift consumer demand.
Chinese policymakers in particular recently turned down an IMF proposal for a trillion-dollar plan to relieve household losses on property through government purchases of pre-sold unfinished housing stock. A bailout would violate “market-based and rule-of-law principles”, they said.
A drastic course change is also unlikely while official growth targets are still being met, Evans said. “If GDP was growing at 3.5 per cent rather than the 4.5 per cent or 5 per cent at the moment, maybe they would be a bit more alarmed.”