The case for Chinese bonds

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Risk: Investments in China are subject to certain additional risks due to issues relating to liquidity and the repatriation of capital. 

The opening of China’s bond market to international investors marks a profound shift in the world’s fixed-income markets. This transformation is still in its early days, but, in our view, looks set to accelerate as investors assess the Chinese market’s compelling combination of diversification and yield.

The inclusion of Chinese bonds in major global bond indices has been underway since 2019. As a result, there have been significant flows into China’s bond market. In 2019, the Chinese bond market had inflows of close to $56 billion. In 2020, this figure rose to $150 billion. And 2021 looks set to exceed that by a wide margin. This is a trend that has much further to run – and one that offers a whole new set of opportunities.

The dynamics of global fixed-income markets make Chinese bonds particularly attractive at present. Many analysts expect negative returns from G7 government bonds over the next five to seven years. With nominal and real rates negative, portfolios around the world are under pressure to answer their investors’ eagerness for income.

Inclusion, yield and diversification

Three forces are at play in driving investors towards Chinese bonds. First, there’s the inclusion of China in bond benchmarks. Then there’s the ongoing search for yield. And, finally, there’s diversification.

Let’s take these one by one. Now that Bloomberg Barclays has completed its phasing-in period, around 7.76% of its Global Aggregate bond index consists of Chinese bonds¹. That includes both government bonds and policy-bank debt. Meanwhile, FTSE has recently started its own phasing-in process, which will take 36 months and will end with China constituting about 5.25% of their World Government Bondindex.² This will drive further inflows as investors adjust to the new composition of their benchmarks. Forward-looking investors may have, in our view, an opportunity to get ahead of the game here.

With regard to yield, it’s important to note that foreign ownership of Chinese bonds is still very low. But more than half of all the bonds globally that yield more than 2.5% are in China.³ Inevitably, therefore, investors who are hungry for yield must think seriously about taking on some Chinese exposure.

Diversification is a critical consideration too. During the big Covid sell-off in 2020, Chinese bonds exhibited very little correlation both to other bond markets and to equity markets. Investors are looking for uncorrelated assets, and Chinese bonds have demonstrated their credentials in this regard.⁴

The opportunity in Chinese credit

As things stand, only just over 3% of China’s onshore bond market is owned by foreign investors. That ownership is heavily tilted towards government bonds and policy-bank debt (which are 10% and 5% foreign-owned, respectively). The credit market, by contrast, is less than 1% owned by foreigners.⁵

That could represent a significant opportunity, in our view. For one thing, Chinese corporate bonds can offer extra layers of diversification. While China’s government bonds have very low correlations to global fixed-income markets, Chinese credit is even less correlated⁶. And China’s onshore credit also has an extremely low correlation to the Chinese dollar-bond market.⁷ Indeed, in the past five years, this correlation has been zero. So, not only do renminbi-denominated Chinese corporate bonds provide diversification, for investors looking for this, away from global bond markets, but they could also offer diversification to investors who already have exposure to Chinese dollar-denominated credit.

On top of that, Chinese credit could enhance both a portfolio’s yield and its potential for outperformance. The onshore credit market has been running for less than 10 years, and its first default occurred only in 2014⁸. So, as a young, underdeveloped and inefficient market, it could provide ample opportunity for alpha generation if investors are prepared to undertake rigorous fundamental research.

Improvements in the offing

In time, we are likely to see reforms of the current credit-rating system for onshore bonds, which is widely believed to lead to inflated ratings. In the meantime, bottom-up investors who are prepared to look through the ratings to the fundamentals should be well placed to find exciting opportunities.

Alongside reform of the rating system, we are also likely to see enhancements in investment protection through covenants and restructuring. As the market improves in this aspect, it’s likely to attract more attention from global investors.

One caveat might be that when the US embarks on a cycle of rate hikes, emerging-market debt tends to underperform. But China’s monetary and fiscal policy is less influenced by the Federal Reserve than that of other emerging markets, and Beijing is keen to keep the renminbi strong to encourage wider use of the currency. So that caveat may be less applicable to Chinese bonds than to other emerging markets.

Many investors are only at the beginning of a long journey here. But more are likely to be attracted to Chinese bond markets as they see improvements in infrastructure, liquidity and creditor protection. In the meantime, there are likely to be considerable opportunities for early adopters.

Note: All amounts given in USD. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or financial product or to adopt any investment strategy. The opinions expressed are as of 01/11/21 and may change as subsequent conditions vary.  BlackRock has not considered the suitability of any investment against your individual needs and risk tolerance.

¹ Bloomberg Barclays, 30 November 2021
² Bloomberg, 29 March 2021, phasing in begun in October 2021
³ Source: WIND, end November 2021
⁴ BlackRock, end April 2021
⁵ People’s Bank of China, WIND, end September 2021
⁶ Bloomberg, end September 2021
⁷ BlackRock, Bloomberg, WIND, end November 2021
⁸ WIND, November 2021 (Shanghai Chaori Solar Energy Science and Technology defaulted in March 2014)