Why Chinese onshore bonds are becoming an indispensable asset class for international investors.
Just over a year after the Covid-19 outbreak began causing economic turmoil around the world, it appears investors may have discovered a new defensive asset: Chinese renminbi debt.
The USD16 trillion bond market has come through the crisis exhibiting the sort of stability normally associated with benchmark US Treasuries.
Not only did it hold up better than developed market government bonds during a tumultuous first quarter of 2020, it has also since traded within much narrower ranges. Its potential as a risk mitigation tool has also been thrown into sharp relief.
Over the past several months, renminbi bonds have not moved in lockstep with the world's other major bond markets. Neither have they tracked emerging market assets. All of which suggests they could turn out to be a good hedge against the riskier assets investors hold in their portfolios.
One explanation for this new-found resilience is that reforms in China have allowed renminbi-denominated bonds to feature more prominently in mainstream global bond benchmarks.
In March, FTSE Russell announced Chinese government bonds will be included in its flagship benchmark indices. That came on the heels of similar moves by JP Morgan and Bloomberg-Barclays.
Index inclusions are landmark developments, both for China and for investors worldwide.
For authorities in Beijing, they are a stamp of approval for their efforts to liberalise the country's capital market and integrate more fully into the international financial system.
For investors, it opens up a new world - one where the renminbi becomes a genuinely global investment currency. In other words, China's onshore bond market will play a far greater role in international bond portfolios.
"China's USD16 trillion onshore bond market will play a far greater role in bond portfolios."
Foreign ownership of Chinese bonds was already rising in anticipation of the index changes.
Non-Chinese investors built up their holdings of RMB debt to RMB3.2 trillion by December 2020, up nearly 50 per cent from the same month a year before.¹
Of the USD9.5 trillion of assets under management from corporate and public pension funds globally, 0.26 per cent was held in Chinese bonds as of the third quarter of 2020, up from 0.04 per cent in 2015.²
Further boosting the market's international standing, China has delivered a series of reforms to make it easier for foreigners to access the market.
Among the most important, the "Bond Connect" programme, launched in 2017, allows non-Chinese investors to trade in Hong Kong without an onshore account. Already, 75 out of the world's top 100 asset managers have joined the programme while trading volume doubled last year to RMB4.8 trillion.³
All of which means the inflows seen since the pandemic are likely to be part of a much larger reallocation. According to the International Monetary Fund, index inclusion alone could result in capital inflows of as much as RMB7.4 trillion into Chinese bonds from international investors.
Opportunities beyond pandemic
Policymakers are also keen to attract foreign funds to hasten the development of the asset management industry across the country.
This is a priority for Beijing as the country's rapidly aging population demands a sustainable pension system.
China's asset management industry - fund houses, insurers and securities and trust companies - is expected to triple in the 10 years to 2028 to RMB47.3 trillion as Beijing removed all foreign ownership restrictions in April 2020.⁴
This should help diversify the domestic and foreign institutional investor base for Chinese securities, which is currently dominated by commercial banks.
Foreign investors make up just under 3 per cent of total holdings today, which we expect to rise to 3.3 per cent this year.
Calm amid turmoil
The opening up of the market comes at a time when the fundamentals of Chinese local currency bonds look particularly strong.
Yields offered by onshore RMB bonds are attractive to international investors as a record USD16 trillion of global bonds yield below zero.
The five-year Chinese government bond yield stands at 2.9 per cent, compared with 0.9 per cent for US Treasuries, -0.1 percent for Japanese Government Bonds and -0.7 per cent for German Bunds with the same maturity - differentials that have never seen before.⁵
Yield is not the only selling point. They also offer a means of diversification. Chinese bonds's returns do not correlate especially strongly with those of any major global asset class - bond or equity.
The correlation of returns from renminbi bonds with those of US and European government debt and equities, for example, is less than 0.2.⁶
What is more, Chinese bonds have exhibited remarkable resilience during historically volatile periods, such as the 2008 global financial crisis and the European debt crisis.
The Covid pandemic was no exception. Renminbi bonds were among the few asset classes to deliver positive returns during the sharp sell-off of the first quarter of 2020, performing more in line with other G10 government bonds.⁷ Of greater significance was that their maximum drawdown for 2020 - their peak-to-trough decline - was just 2.2 per cent, a fraction of the losses endured by global bonds (around 9 per cent) and US dollar investment grade credit (over 15 per cent).⁸
Chinese local currency bonds have also proved to be historically resilient to rising US yields. In the most recent global bond market sell-off, they have performed better than any other fixed income asset classes (see chart). This further reinforces their standing as a defensive asset.
RMB - an international currency
As the world's second largest economy matures, Beijing is committed to opening up its financial market and promoting the greater use of the Chinese currency abroad.
The authority has already established the CIPS, a payment system which offers clearing and settlement services for its participants in cross border RMB payments and trade, and opened commodity futures contracts in the RMB.
China's drive to internationalise the RMB also includes some innovative projects. For example, the People's Bank of China issued digital currency in October to 50,000 randomly selected consumers in what is its first public test of the digital payment system.
Pilot schemes like this should also help encourage users in other countries to use the RMB. The RMB is already the world's fifth largest reserve currency but it accounts for just under 2 per cent of the total central bank reserves.
If that share were to double, it would amount to an additional RMB1.5 trillion of RMB bond investments, the IMF says.⁹
According to Pictet Asset Management's economists, it won't be long before the RMB's share of international reserves is greater than that of the British pound.
All of this is likely to lead to a greater appreciation of the RMB, which should contribute strongly to the total return of investors' bond portfolios.
Going green
Another favourable development is China's recent announcement that it plans to be carbon neutral by 2060.
The ambitious goal is likely to require as much as USD16 trillion of investments, where we believe green bonds will be an important channel.
The PBOC has already promised to improve the country's green finance standards to support the 2060 goal and make it easier for foreign investors to enter the green finance market.
As of June 2020, China's outstanding green bonds totalled RMB1.2 trillion, the second largest in the world.
This figure should grow in the coming years, helping expand the universe and increase the depth of the Chinese onshore bond market in the long term.
"RMB-denominated bonds should become an even more integral part of global fixed income investors' portfolio."
With its population ageing rapidly and its investment needs rising as a consequence, China has every incentive to remove restrictions on the flow of capital across its borders and drawing in foreign funds.
And nowhere other than the RMB onshore bond market can investors see China's economic transformation more clearly in the coming years.
As the year of the Ox promises to bring growth for Chinese RMB-denominated bonds, the asset class should become an even more integral part of global fixed income investors' portfolio.
[1] Wind, Standard Chartered Research as of 31.12.2020
[2] eVestment/Reuters
[3] Bond Connect as of 31.12.2020
[4] Roland Berger, on mutual fund assets under management basis
[5] Yield in local currency as of 07.04.2021. Source: Bloomberg
[6] All indices are total return and in USD unless indicated. Based on monthly data from 31.10. 2008 - 31.12. 2020. Source: Chinabond, JP Morgan, HSBC, Bloomberg
[7] Source: Chinabond, JP Morgan. All indices are total return and in USD. Based on the following periods: Great Financial Crisis (Aug-Oct-2008); EU sovereign debt crisis (Aug-Nov 2011); Covid-19 (21.02.2020-15.04.2020)
[8] Bloomberg Barclays China Composite index, USD unhedged basis, global agg and USD IG Source: Bloomberg Barclays
[9] IMF: The Future of China's Bond Market, March 2019
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