Opportunities for yield and income in China

Addressing investors’ pressing needs in a post-pandemic world

Setting the scene

The world’s hunt for income and yield has been an issue for decades that will likely continue. People are living longer and retiring in record numbers, while Covid-19 triggered a race to near- zero interest rates in developed countries. The U.S. currently has US$17+ trillion worth of bonds with negative yields, which is roughly the size of the entire Chinese bond market, where most bonds yield more than 2.5% are found (see chart below). We believe the recent strong net inflows validates the attractiveness of Chinese fixed income markets and are indicative of future flows.

Global investors have historically shied away from owning Chinese assets citing a lack of market sophistication and limits on ability to access the onshore markets. Portfolios have traditionally held very small quantities of Chinese assets via aggregate emerging market (EM) exposures.

This is changing rapidly. Recent inflows reflect the larger Chinese representation in international indices, but also growing recognition that Chinese markets are entering a more mature phase well-positioned to help the global investor. A few catalysts are:

Attractive yields
Most developed-market government bonds can’t serve as portfolio ballast at current yields, and Chinese bonds can help investors fill this void.
Healthy diversification
The Chinese bond market has had low correlations to global fixed income.
Positive fundamentals
The strong economic recovery and increased differentiation of Chinese issuers create opportunities for active credit selection.
Relative valuation
Diverging performance of the offshore USD versus onshore RMB credit enables alpha opportunities by allocating between the two markets.

Global bonds yielding more than 2.5% by market

Global bonds yielding more than 2.5% by market

Source: BlackRock, Wind, December 2020. Based on the Bloomberg Barclays Multiverse and all eligible China onshore bonds - both rates and credit bonds (>1billion CNY size, >1 year maturity). DM and EM stand for developed and emerging markets, respectively.

Does index inclusion help open up Chinese bonds to foreign investors?

China has the world's second- largest bond and credit markets after the U.S. Inbound flows have indeed accelerated due to inclusion in global indices, but credit bonds aren’t in this scope, leaving out a large portion of the investable universe where attractive opportunities lie.

The Chinese bond market is about US$17 trillion1, surpassed only by the US$49 trillion2 market. Index inclusion has eased Chinese bonds into asset allocation considerations, while offering a fairer representation in international indices. In December 2020, Chinese bonds accounted for about 6% of the Bloomberg Barclays Multiverse Index, the broadest measure for global fixed income. However, credit bonds, a significant part of the investable universe aren’t part of the inclusion (see the Two bond types chart). This is important because investors that are benchmark constrained or aware, may not benefit from the potential alpha generation that credit offers (assuming investors can navigate certain complexities of Chinese credit markets).

State-owned enterprises (SOEs) represent over a quarter of China’s onshore credit market (see chart). The SOEs’ significance varies widely between central and local governments and understanding their relative rank may prove as crucial to understanding the issuer’s standalone fundamentals to determine its creditworthiness. The different methodologies used by domestic and international credit rating agencies create another set of complexities. Understanding these differences is critical to assessing ratings fairly, especially since domestic agencies dominate in this market.

Two bond types

Composition of China’s onshore bond market, 2020

Composition of China’s onshore bond market, 2020

Source: Wind, December 2020. Policy bank bonds are owned by the central government and serve policy function; local government bonds are offered by the provinces.

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What are the diversification benefits of Chinese bonds?

Chinese bonds can offer portfolio ballast, attractive yield and diversification based on the onshore and offshore nature of the market.3

Drivers of uncorrelated returns

Drivers of uncorrelated returns

The Chinese bond market can go beyond addressing the need for yield in the post-Covid-19 world. The ‘More than a yield pick up’ chart alludes to potential benefits from diversifying into China’s credit - higher yields and income per unit of risk to the equivalent U.S. bonds, even unhedged. This compliments the dual diversification potential of the low correlations between China and other major bond markets and among the onshore RMB and offshore USD Chinese credit markets – highlighted in the Alpha opportunity through tactical allocation chart. In China, yields from the same issuer may differ across markets, enabling managers to exploit such differentials for alpha generation, while taking similar credit risks.

Risk-free rates vary by market. Onshore credits are RMB-denominated and sensitive to Chinese monetary conditions and other onshore-market factors. Most offshore credits are U.S.-dollar denominated, subject to global risk factors.

More than a yield pick up

U.S. corporate yield and various credit yields in China, 2020

U.S. corporate yield and various credit yields in China, 2020

Source: Bloomberg. December 2020. Bloomberg US Corporate Index (US IG corporate), JP Morgan JACI China IG Index (Offshore IG Credit), China Bond New High Grade Index (Onshore IG Credit), BlackRock Cross-Border Strategy (Cross-border). Past performance is not a reliable indicator of current or future result. Indices are unmanaged and one cannot invest directly in an index.

Alpha opportunity through tactical allocation

China’s bond market annualized returns, 2017–2020

China’s bond market annualized returns, 2017–2020

Source: BlackRock, December 2020. USD China Bond represented by the J.P. Morgan Asia Credit Index (China CNH hedged); Onshore Bond represented by the China Credit Bond Index. Past performance is not a reliable indicator of current or future result. Indices are unmanaged and one cannot invest directly in an index. Any opinions, forecasts represent an assessment of the market environment at a specific time and are not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research, investment advice or a recommendation.

What about default risk?

Chinese bond defaults still lag other high yield markets. Even though we may see an increase in Chinese credit defaults this year, we do not see it as a systemic risk. China’s willingness to make financial reforms quickly, can have a meaningful impact on credit quality and transparency.

We see a potential uptick in Chinese credit defaults this year, but not enough to pose systemic risks to the onshore bond market. China’s default rate significantly lags that of its global counterparts, despite pandemic-related stresses. For example, annual defaults in U.S. high yield nearly doubled last year, and while reversion to pre-Covid-19 levels is plausible, in 2021 U.S. defaults may top China’s by nearly a two-to-one ratio (see the Staying in business chart).

Stories about the rising risks of Chinese defaults have grabbed attention from many global investors, masking what in our view should be their main concern: the sustainability of returns. The speed and efficacy at which China can forge its financial markets’ reforms should have more meaningful and lasting effects than any isolated event. Defaults are part of the story; they just aren’t the main part.

The initial wave of defaults preceded the escalation of the U.S. China trade tensions in 2018, which cut short the government’s deleveraging effort, as further aggravated in Q1 2020 by the Covid-19 pandemic. However, China’s V-shaped economic recovery facilitates a return to the deleveraging path.  We see this gaining force by this year’s second half, along with tightening to prevent overheating, especially in the hot property sector. This scenario fits well within a bigger picture.

Chinese regulators have long sought to raise the financial market transparency and support paths toward maturity in the credit cycle (e.g. deleveraging and removing the moral hazard of implicit guarantees for local SOEs). The market is now poised to further differentiate credits and improve pricing, which are positive signs for investors.

Staying in business

Actual and projected default rates for various asset classes

Actual and projected default rates for various asset classes

Projections are for 2021, as of January 2021. Source: Wind, J.P. Morgan. Projections are from J.P. Morgan except China onshore HY (high yield), which is based on BlackRock calculations. This chart is for illustration purposes and there is no guarantee that any forecasts made will come to pass. Indices are unmanaged and one cannot invest directly in an index.

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Looking ahead: China’s bonds in a post-pandemic environment

Relevant topic

Pre Covid-19 and during shock

Post pandemic world

 

Income needs

•   In a world of few income sources and high demand, Chinese bonds stand out for their yield and stability
•   Breadth of opportunities in Chinese credit and low correlations to global credit creates an opportunity for investors to diversify their income sources

•   Aging demographics = sustained demand for yield
•   With rates close to zero across most of the world, yield differentials become material considerations
•   56% of global bonds yielding >2.5% come from China

 

 

Market structure

•   Onshore renminbi market was effectively the sole large bond market that avoided a liquidity crunch in 1Q 2020, offering diversification for global portfolios
•   Deleveraging process began prior to the Covid-19 crisis.
•   Zero correlation of onshore/offshore markets despite the same underlying fundamental risks

•    Preemptive policy action enabled a V-shaped recovery, underscoring China’s potential as a global growth engine and enhancing global credibility
•    We see credit defaults leading to better pricing of risk, providing investors with potential investment opportunities

 

Risks

•   Potentially devastating effect of Covid-19 effectively mitigated by macro and social policies

•   Escalation of U.S.-China competition leading to barriers, restrictions on cross-border investments
•   We see the latest series of defaults in China as integral to its credit cycle and not as a sign of systemic risk

 

 

 

Opportunities

•   The race to the bottom in global government bond yields hasn’t happened in China, and the V-shaped economic recovery may avoid it
•   Chinese government bonds offer one of the highest real yields, with tailwinds from index inclusion

•   Index inclusion and lowered barriers to entry facilitates ownership by foreign investors, which now represents ~3% of the total onshore market
•   The structural hunt for yield points to a case for strategic allocation to China
•   Diversification through the low correlation to global bonds and alpha opportunities with a low correlation of RMB/USD Chinese credit
•   Participation in the market that is leading global economic recovery post Covid-19

Investment themes based on the overarching theme of divergence

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The strategic versus the non-strategic credits
Government-related credits dominate the onshore credit market, but the influence of state-owned enterprises varies. Uncovering this nuance entails rigorous research.
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The credit haves versus the have-nots
Onshore bonds offer attractive yields. But the market is complex, and alpha generation potential is dependent on careful asset allocation and security selection.
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The domestic versus the international credit ratings
International rating agencies have started to evaluate the onshore market more, but domestic players still dominate. Onshore AAA ratings come close to an IG rating offshore.
Eric Liu, CFA, FRM
Portfolio Manager, BlackRock Asian Fixed income and Credit team
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Corwin Huang
Product Strategist, BlackRock Asian Fixed Income and Credit
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Lisa Li, CFA, FRM
Product Strategist, BlackRock Asian Fixed Income and Credit
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Gregor Carle
Head of Fixed Income and Credit Product Strategy for APAC
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