China’s sluggish economic growth, growing geopolitical risks and the troubled property sector may have prompted some global fixed income investors to purge the country’s bonds from their portfolios.
But that has proven to be a costly decision.
Evidence shows investors who stayed away from Chinese bonds have forgone the potential for making double-digit returns in this market over the past years.
Chinese government bonds have delivered strong performance thanks to the country’s easy monetary policy – in contrast to aggressive tightening by other major central banks – as well as domestic safe-haven inflows.
The market will likely remain a source of stable return in the coming years. One reason is cyclical – a recovery in the world’s second largest economy is likely to be steady yet slow. Domestic headline inflation remains well below the official 3 per cent target, at a time when inflationary pressures in other major economies are proving sticky. What is more, the fortunes of the renminbi currency are likely to turn around in the medium to longer term after a relentless slide in recent years.
Another reason is structural. Chinese onshore bonds represent a defensive investment, providing an anchor for a global portfolio with the potential for attractive returns that are uncorrelated with other major government bond markets.
Standout performance
Chinese onshore bonds have made robust gains in the past few years while achieving lower volatility than many developed and major fixed income markets.
Take a typical EUR-based investor. Over the last five years, Chinese onshore bonds – largely sovereign but also including corporates and policy banks – would have returned them over 15 per cent on a currency hedged basis, comparing favourably with euro zone investment grade bonds, which lost 2.7 per cent, or euro zone government bonds, which suffered a loss of over 7 per cent.EUR hedged investment in the Bloomberg China Agg index, covering period 31.05.2019 and 31.05.2024
Euro zone high yield bonds enjoyed similar gains at almost 15 per cent, yet with a higher volatility. For USD-based investors, the findings become even more striking, with returns of Chinese bonds outpacing those of US Treasuries and high yield counterparts (see Figure).
Five-year annualised return, volatility and cumulative performance
| China bond AGG hedged USD | USD IG | USD HY | USD SOV | Global AGG hedged USD | ||
|---|---|---|---|---|---|---|
Annualised return | 4.60% | 1.00% | 4.20% | -0.70% | 0.40% | |
| Annualised volatility | 1.60% | 8.90% | 9.20% | 5.50% | 4.40% | |
| Cumulative return | 25.10% | 5.00% | 22.80% | -3.30% | 1.80% | |
| China AGG hedged EUR | EUR IG | EUR HY | EUR SOV | Global AGG hedged EUR | ||
| Annualised return | 2.90% | -0.60% | 2.80% | -1.60% | -1.50% | |
| Annualised volatility | 1.60% | 4.80% | 7.90% | 5.50% | 4.40% | |
| Cumulative return | 15.28% | -2.77% | 14.96% | -7.61% | -7.10% |
Source: Bloomberg as of 31.05.2024. All Bloomberg indices: EUR-hedged China Aggregate, EUR Agg corporate, Pan-European HY, Euro Agg sovereign. All Bloomberg indices: USD-hedged China Aggregate, USD Agg corporate, US HY, US Treasury, Global Agg.
In the near term, we expect Chinese bond yields to remain stable. Monetary policy should remain loose in the absence of inflation, offsetting the potentially negative effects of an increase in both bond supply and public spending.
The bond market should also draw support from measures to stabilise the Chinese property sector. The People’s Bank of China has announced a range of policies including a reduction in down payments, as well as plans for government purchases of private properties that will then be converted into public housing. This should help ease strains in the market and also enable the central bank to keep rates low.
As for corporate issuers, policy support provides a positive backdrop for high-quality credit in both onshore and offshore markets, especially in the property sector. We think real estate state-owned enterprises are attractive thanks to better funding resources. We also prefer bigger banks which have solid capital ratios.
PBOC's potential intervention
Some investors may have become nervous over the People’s Bank of China’s plan to start selling sovereign bonds to tame a bond market rally which it believes is endangering financial stability.
We don’t think this is a cause for concern.
First, bond buying and selling is part of normal policy measures for a central bank to manage liquidity and prevent a one-way price action in government bond yields. Even if the PBOC does intervene, it will be to prevent too rapid a decline in bond yields, rather than actively tightening policy.
What is more, any move would likely be well-publicised and thus unlikely to catch the market off guard.
RMB: eyeing structural gains
In the long term, foreign exchange will offer an additional source of returns for those who prefer not to take a currency hedge.
This is because the fortunes of the Chinese renminbi could turn around in the very long term.
The RMB has experienced protracted weakness in the past year. This was in part due to China's slow growth, but also monetary policy divergence. The Federal Reserve raised interest rates aggressively at a time when Chinese monetary policy remained easy – which has made the country's bonds so lucrative in the first place. But capital outflows from China’s financial markets should subside as the economy stabilises.
Already, there are tentative signs that capital is flowing back into China, especially in the fixed income market which has experienced outflows of nearly USD10 billion since the start of last year.Source: Institute of International Finance, net non-resident purchases of Chinese bonds, covering period 01.01.2023 - 30.06.2024
That said, a true RMB appreciation may take time to come through. Our five-year forecast shows the Chinese currency to rise 2.8 per cent per annum in the next five years against the dollar.See Secular Outlook 2024, Pictet Asset Management
China’s bond market is too big an asset class to ignore for global investors.
Demand for Chinese sovereign bonds is likely to remain strong. The lack of low-volatility investment opportunities should make Chinese government bond investments attractive for many investors, especially at a time when the country’s stock market remains under pressure and the economy recovers only slowly.
Despite recent macroeconomic challenges, China’s USD21 trillion bond market, the second largest in the world, is too big an asset class to ignore for global investors.
