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China’s government bond market—the world’s third largest—has become too big to ignore. It combines attractive income and capital appreciation potential with exposure to a rapidly growing economy. Yet foreign ownership in this growing market remains low. We think now is the time for that to change.
We think there are four important reasons for investors to consider increasing allocations to Chinese government bonds:
China’s post-pandemic recovery has been strong. As Exhibit 1 illustrates, China is among the handful of countries that has not only recovered its pre-pandemic output but is also running well above levels seen at the end of 2019.
Source: Goldman Sachs Asset Management
China was “first in, first out” from the pandemic. The country’s factories were among the first in the world to close when COVID-19 began spreading in early 2020 but were able to reopen earlier as infection rates in China slowed.
In 2021 we expect growth composition to be more domestically-driven as vaccination rates and income rise, with manufacturing investment and consumption being key.
Self-sustaining, domestically-driven growth reduces the need for the fiscal and credit expansion the government relied on to offset the effects of the pandemic and the US-China trade war. Instead, we expect to see credit tightening this year. On the currency the macro backdrop is favourable with still strong growth, a current account surplus and interest rate differential in favour of China. We expect the CNY to appreciate over the coming year against key developed-market (DM) and emerging-market (EM) currencies.
All of this means Chinese government bonds have offered an attractive yield premium over comparable maturity DM bond yields—even when we take into account the recent rise in global rates. For instance, Chinese bonds have offered a 150-basis-point pickup over comparable US Treasuries, where yields have been pinned down by a slower rate of growth and the Federal Reserve’s indication that it intends to keep interest rates on hold until 2023.
When looked at as part of an overall fixed income portfolio, Chinese government bonds may also act as a powerful diversification tool. Correlations are low with other major bond markets—both developed and developing—and major global bond indices. We believe exchange traded funds can potentially provide a cost effective and simple way to gain access to Chinese government bonds.
In addition to attractive yields, Exhibit 2 shows that Chinese bonds have typically come with considerably lower volatility relative to other developed market debt.
Source: Bloomberg, Standard & Poors. As of May 31, 2021
By October 2021, China will be included in three major global bond indices. That could result in cumulative investment flows in the range of $250 billion to $300 billion, which we believe may spark yield compression and capital appreciation.
In addition, the People’s Bank of China has taken steps to grow the market further by making it easier for foreign investors to trade. Increasing access, in our view, will likely increase market liquidity, further solidifying China’s important role in the global market and in a diversified fixed income portfolio.
Though not thought of as a leader in this area, the country is moving in the right direction. Our fixed income proprietary scoring system for developed and emerging markets puts China in the middle of the pack, in line with its peers, when it comes to ESG.
The country rates higher on social and governance factors than environmental ones, where it scores poorly. But we’re encouraged by the government’s focus in its current five-year plan on reducing greenhouse gas emissions and improve air quality. There’s a long way to go, but we think the country is on the right track.