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May 05, 2022 | GSAM Connect

The Case For China Government Bonds Has Become Even Stronger

2021 reaffirmed the benefits of investing in China government bonds (CGBs), with yields largely insulated from coordinated moves in global bond markets. The recent dovish policy shift in China has made the case for CGBs even more compelling, in our view. Below, we discuss the macro backdrop for CGBs in 2022 and why we think these assets offer an attractive mix of income and price appreciation potential.

CGBS MAY CONTINUE TO BENEFIT FROM LOOSE MONETARY POLICY, DESPITE A CHALLENGING ENVIRONMENT FOR GLOBAL FIXED INCOME MARKETS IN 2022

We believe that sustaining a benign macro environment with firm growth and financial stability will be paramount ahead of China’s 20th Party Congress due to be held in the second half of this year. While we do not expect policymakers to deviate from the medium-term goal of deleveraging in the property sector, we do think recent developments point to some further targeted loosening of both monetary and fiscal policy in 2022.

Indeed, amid growing concerns about the economy, China’s policy stance has shifted from over-tightening for most of 2021 towards easing in recent months. Following calls for more support to the real economy, the People’s Bank of China (PBoC) cut the reserve requirement ratio (RRR) for banks twice since December, and announced a 10 bps cut to the one-year medium-term lending facility (MLF) and the 7-day reverse repo rate in mid-January. Authorities also emphasized “growth stabilization” as the top priority for 2022.

Inflation is relatively under control in China, so there is no urgency for the PBoC to tighten policy, in sharp contrast to the US, the UK and other major economies where persistent inflationary pressures have forced central banks to pull forward policy normalization.

CHINA BONDS OFFER A STRONGLY POSITIVE REAL YIELD IN A WORLD WHERE INCOME IS INCREASINGLY HARD TO COME BY

Admittedly, diverging monetary policies in major economies and China could lead to a narrowing of yield differentials and chip away the carry advantage of CGBs. Indeed, the strong absolute and relative performance of CGBs in 2021 can be attributed to the Chinese government maintaining a tighter monetary and fiscal stance that has helped CGBs retain an attractive yield level relative to other global government bond yields.

That said, in nominal terms the China 10-year still offers just under 90 bps of pick-up over UK Gilts and roughly 200 bps over German Bunds. In real terms, the comparison is even more compelling since inflationary pressures in China are relatively contained. Exhibit 1 shows that, among investment grade issuers, China is a rare exception in offering a positive real yield without the need to stretch on credit rating. Therefore, we believe investors who are hungry for yield must think seriously about taking on some Chinese exposure.

Exhibit 1: Real 10-year[1] sovereign bond yields for IG issuers

 

Source: Bloomberg, Moody’s, Goldman Sachs Asset Management. As of 20 April, 2022.

THE RENMINBI IS LIKELY TO REMAIN STRONG, DESPITE THE PROSPECT OF A SHRINKING INTEREST RATE DIFFERENTIAL WITH THE US

Of course, FX exposure should always be factored into any investment decision. We think that the renminbi will remain well supported against the US dollar in 2022 as China maintains a meaningful current account surplus. Net portfolio inflows driven by index inclusions and a potential acceleration in equity purchases by foreigners with domestic stocks likely performing better this year are additional tailwinds. A narrowing of yield differentials with US Treasuries as a result of looser monetary policy in China compared to the US could put some downward pressure on the Chinese currency. But we believe the potential support of such a monetary policy action for the real economy and domestic assets should mitigate the impact on the renminbi.

INDEX INCLUSION AND DIVERSIFICATION BENEFITS WILL DRIVE FOREIGN INFLOWS

There are a few additional factors that may help drive strong investor inflows into China’s government bond market in 2022.

To start with, there’s the inclusion of China in bond benchmarks. This has already driven inflows into the asset class and is set to further increase foreign ownership of China government bonds as international investors adjust to the new composition of their benchmarks. As a reminder, Chinese bonds are now part of three major bonds indices: the Bloomberg Barclays Global Aggregate Bond Index, the JP Morgan GBI-EM Index, the FTSE World Government Bond Index. Exhibit 2 shows the actual or expected weight of Chinese bonds in these indices once the phasing-in period is completed.

Exhibit 2: Index inclusion will lead to significant passive flows

 

Source: Bloomberg Barclays, JP Morgan Asset Management, Goldman Sachs Asset Management. Past correlations are not indicative of future correlations, which may vary. The economic and market forecasts presented herein are for informational purposes as of the date of this presentation. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this presentation.

In addition, we’re seeing increased demand from reserve managers. We believe global central banks want to increase exposure to China’s government bonds as the renminbi gains in status, provided the government follows through with more financial market liberalization.

Finally, CGBs offer diversification benefits in the current environment. During the pandemic selloff of early 2020, Chinese bonds exhibited very little correlation either to other bond markets or to equity markets. Investors are looking for uncorrelated assets, and Chinese bonds have demonstrated their credentials in this regard. Exhibit 3 shows how CGBs can meaningfully improve the frontier of expected returns of global fixed income portfolios, especially for lower levels of targeted risk.

Exhibit 3: Fixed Income assets (USD-hedged) efficient frontiers estimates

 

Source: Goldman Sachs Global Investment Research. As of March 23, 2022. The economic and market forecasts presented herein are for informational purposes as of the date of this presentation. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this presentation. These results are based on simulated or hypothetical performance results that have certain inherent limitations. Unlike the results shown in an actual performance record, these results do not represent actual trading. Also, because these trades have not actually been executed, these results may have under-or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to these being shown. Please see additional disclosures.

THE TAKEAWAY: ATTRACTIVE INCOME, WITH MORE ROOM TO RUN

We see considerable upside potential in Chinese government bonds. For income-oriented investors, yields remain attractive relative to comparable developed market debt, especially once inflation is taken into account. Over the next 12-18 months we expect potential monetary policy easing, continued strength in the renminbi, an increase in foreign investor demand, and the need for greater diversification to push prices higher. We believe the macroeconomic case for foreign investors to increase their allocation to this market is compelling—particularly at a time when finding reliable yield in real terms remains a challenge.

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ABOUT THE AUTHOR

Simona Gambarini

Simona Gambarini

Senior Market Strategist, Strategic Advisory Solutions, Goldman Sachs Asset Management

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