Will Chinese Government Bonds Remain A Safe Haven?

By Zhaoyi Yang, Fixed Income Research, FTSE Russell

Favorable factors such as relatively higher yields vs G7 government bonds and a defensive currency, have helped Chinese government bonds outperform in 2021.

Compared to G4 and global government bonds, Chinese government bonds have registered higher quarterly, and annual, returns for both domestic and dollar-based investors, as Table 1 shows. In particular, they provided a safe haven during the Covid reflation trade in Q1 2021, when the World Government Bond Index (WGBI) registered its worst quarterly returns since Q4 2016. It could also be surprising to note that the Chinese sovereign bonds’ returns almost matched those of US high yield credit bonds for the year (5.1% vs 5.4%),with the strong yuan boosting their returns to 7.9% in US dollar terms. From a risk perspective, the Chinese government bond index has also provided favorable risk-adjusted returns since 2009, as discussed in previous research^[1], and also during 2021, with consistently low standard deviations.

Chinese sovereign yield spreads remain under the spotlight, with a dovish PBoC vs a hawkish Fed, continuing into 2022

Chinese government yield spreads vs other major bond markets fell sharply in 2021, as shown in Chart 1, particularly so, in Q1 2021, when G7 yield curves steepened in the reflation trade, while the PBoC stayed firmly on hold through the year. Despite spreads returning to pre-Covid levels as G7 bond yields surged (Chart 1), Chinese yield premia over G7 yields remained substantial, i.e., Chinese government yield spreads vs US Treasuries mean-reverted to about 140 basis points, from a high level relative to history.

The unexpected move by the PBoC in its January 2022 open market operations, when it lowered both the Medium-term Lending Facility rate, or MLF, and the 7-day reverse repurchase rate by 10 basis points, highlighted the dovish tone by the central bank, which promised to support the real economy facing strong economic headwinds. As in other sovereign bond markets, Chinese bond yields have historically tracked the monetary policy interest rates. Therefore, easier monetary policies have led to an expectation of the yield spread narrowing further in the year ahead, given the anticipated interest rates hike by hawkish Fed. Chinese 7-10 year yield spreads over US Treasuries 7-10 year reached a 32-month low in January 2022, at 99 basis points, following the rate cut.

Currency risk persists for foreign investors, although renminbi has demonstrated some resilience in 2021 vs the US dollar, compared to vulnerable EM currencies

Investors of renminbi-denominated bonds are exposed to currency risks, if based in other currencies, and currency hedging costs vary according to the home currency of investors. As substantial trade surplus, large currency reserve and capital inflows may continue to support the renminbi, the Fed’s tightening policy to counter rising inflation could boost the US dollar, to some extent, through higher interest rates. One may argue that narrower bond yield spreads between China and the US have been mostly accompanied by a stronger US dollar historically. Therefore, the renminbi is likely to depreciate in 2022 should history repeat itself, given that the divergence in monetary policy between central banks is expected to further close the yield gap. However, recent history since January 2021, as shown in Chart 2, seems to suggest the opposite, with renminbi holding up well following tighter spreads. This inconsistency, perhaps due to Chinese monetary policy frontrunning that of the Fed (and other major central banks), leaves some uncertainty on the CNY/USD currency movement as economic recoveries remain mixed globally.

More importantly, it is worth bearing in mind that the PBoC will make its efforts in pivoting the renminbi value if it floats outside of its defined ranges, as maintaining stability within the economic growth and the exchange rate is the base line.

Relatively lower, but steadily growing, foreign participation suggests potential in interests by overseas investors

In addition to its higher yields in the current low-yield world, Chinese government bond yields have a low correlation with those of G7, and thus the portfolio diversification benefits may also have attracted foreign investors into the Chinese government bond market, which is less exposed to the global financial cycle. Independent policy regimes, as again proved during the Covid shock since March 2020, and the lower foreign ownership of Chinese government bonds, at about 10%, could help to explain the limited connectivity between China and other major bond markets. Inclusion of Chinese government bonds in global bond indices is another key driver, as ‘passive’ approaches to portfolio management become more important, in particular when matching the market’s weighting is required.

Regulatory reforms since 2016 have substantially improved foreign access to the Chinese onshore bond market, including improved market facilities for overseas investors to hedge out currency exposure, therefore boosting foreign participation, particularly so in recent years. Also, tax benefits are offered to attract foreign investment to the domestic bond market, such as the extension of tax exemption on bond interests for foreign institutional investors until the end of 2025. Apart from the increasing foreign ownership to above 10% latest, compared to only 2% in 2014, the fact that 80% of net issuance of Chinese government bonds in the primary market were purchased by foreign investors, in the first seven months in 2021 may be another evidence of the active participation by international investors in this market. It is widely believed there is more potential for the market to open to overseas investors in the future, with more measures and enhancements to be introduced into China’s financial market (e.g., if open-ups in the bond derivative or repurchase market are applied).

[1] Chinese bond market: Evolution and characteristics, July 2020.

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