China, Explained series: The case for onshore China bonds in a low-yield environment

1 Upward pressure on the RMB is expected in 2021 however at a slower rate than in 2020

2 Onshore bonds can act as a hedge against a weak US dollar backdrop and may provide higher yields as well as diversification benefits

3 Demand for RMB-denominated bonds from global investors is growing and we favor credits with solid balance sheets or access to financing.

RMB appreciation expected in the medium term

Since the rollout of COVID-19 vaccines late last year, the global economy has been on the path to recovery and China has taken the lead. Despite US dollar volatility, China posted a healthy trade surplus¹ and saw capital inflows supporting domestic equity and bond markets in 2020. As money supply and fiscal stimulus from the US increases and China’s GDP growth accelerates at a faster rate than other global economies, we believe there will be upward pressure on the RMB in the medium term.

We expect broad RMB appreciation to be supported by fund inflows exceeding outflows but limited by potential risk factors such as deteriorating US-China trade relations and policy tightening. Relative to 2020, the pace of RMB appreciation is likely to slow down this year given that policymakers are opening channels for capital outflows from domestic capital markets (i.e. expansion of QDII quotas²). 

Onshore bonds as a US dollar hedge and diversification play

We believe that RMB-denominated bonds can act as a hedge against a weak US dollar backdrop and provide higher yields as well as diversification benefits. The spread between Chinese sovereign onshore bonds and US treasuries during 2020 provided a meaningful pick-up in yield to the tune of 200 basis points which is significantly higher than the approximate 100 basis points spread during pre-COVID days. This spread differential could narrow from either a sell-off in US treasuries or further appreciation in Chinese government bonds.

The draw of onshore bonds is its low correlation with other global asset classes. For example, during the Q1 2020 market crash, demand for RMB-denominated fixed income was stable while equities, EM sovereigns and US treasuries sold off. In the last year, RMB asset prices have been supported due to the effective management of China’s capital account. With a market size of over 100 trillion yuan³ and an annualized turnover of almost 3% in 2020, China’s bond market is now the second largest in the world and boasts relatively deep liquidity and convenient access.

Increased demand from global investors and opportunities in 2021

Global investors have been increasing their allocations to RMB assets in recent years propelled by the addition of the currency to the IMF’s Special Drawing Rights (SDR) basket as well as the inclusion of onshore government and policy bank bonds to major global fixed income indices.⁴ Overseas pension funds in particular are investing in RMB-denominated bonds through either through direct investments, ETFs, or other fund structures.⁵

The findings of Invesco’s Global Fixed Income Study 2019 also found that investors globally are allocating more to China fixed income, for example 68% of APAC investors reported some level of exposure.⁶ The survey respondents represented a broad investor base including pension funds, insurers, sovereign wealth funds and wholesale investors such as private banks.

While demand is growing, the current foreign ownership ratio in the Chinese bond market is still relatively low at 3% (9% for government bonds specifically)⁷ compared to roughly 30% for US treasuries.⁸ There is ample room for this ratio to grow as China’s capital markets open further.

In 2021, we take a neutral stance on Chinese government bonds, yet they are still attractive given carry and currency gain. Regulators have signaled a cautious approach to monetary policy and open market operations. As such we are cautious on sectors that face idiosyncratic and higher default risks from policy tightening or sectors that are sensitive to geopolitics. Instead, we favor credits with solid balance sheets or access to financing.

Investment risks

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

When investing in less developed countries, you should be prepared to accept significantly large fluctuations in value.

Investment in certain securities listed in China can involve significant regulatory constraints that may affect liquidity and/or investment performance.

_{^1 Bloomberg. China Ends 2020 With Record Trade Surplus as Pandemic Goods Soar (January 14, 2021). https://www.bloomberg.com/news/articles/2021-01-14/china-s-trade-surplus-hits-record-as-pandemic-fuels-exports?sref=xv12TOW5
^2 AsianInvestor. China’s QDII quota easing “could be start of a trend” (November 11, 2020). https://www.asianinvestor.net/article/chinas-qdii-quota-easing-could-be-start-of-a-trend/464785
^3 AsianBondsOnline. People’s Republic of China (Sources: ChinaBond, Wind Information and Bloomberg, LP). https://asianbondsonline.adb.org/economy/?economy=CN
^4 Singapore Exchange. Gain Direct Exposure to the World’s 2nd Largest Bond Market (November 23, 2020). https://www.sgx.com/research-education/market-updates/20201123-gain-direct-exposure-worlds-2nd-largest-bond-market
^5 Reuters. Irresistible? Pension funds plot move on China's $16 trillion bond market (January 20, 2021). https://www.reuters.com/article/us-global-bonds-china-insight-idUSKBN29P02P
^6 Invesco. Invesco Global Fixed Income Study 2019 (March 18, 2019).  https://www.invesco.com/content/dam/invesco/apac/en/pdf/insights/invesco-global-fixed-income-study-2019/20190318-Invesco-Fixed-Income-Study-2019-Asia-by-Invesco-Fixed-Income.pdf
^7 DBS Bank. China’s onshore bond and FX markets (March 4, 2021).
https://www.dbs.com/aics/templatedata/article/generic/data/en/GR/092020/200924_insights_china_primer.xml
^8 US Department of the Treasury. Foreign Portfolio Holdings of U.S. Securities (June 28, 2019). Https://ticdata.treasury.gov/Publish/shl2019r.pdf}

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