Zhaoyi Yang, FRM and Sandrine Soubeyran, Global Investment Research, FTSE Russell
Foreign investors have shied away from Chinese bonds since 2022. Why, and was it wise?
Foreign investments in all categories of Chinese bonds via direct investment in the China Interbank Bond Market, or CIBM Direct, have fallen to 2.3 trillion yuan in April 2023, from a peak of 2.8 trillion in January 2022[1] as shown in Chart 1. A similar declining trend can be observed via the Bond Connect northbound trading[2], which offers a separate channel for international institutional investors to access the Chinese bond market via Hong Kong.
Even Chinese government bonds, one of the most liquid and popular instruments with foreign investors, have registered capital outflows. Since February 2022, foreign participation has fallen to pre-Covid levels, below 10% (Chart 2). An important reason behind this declining interest has been the smaller yield premium of Chinese bonds compared to G7 bond markets (Chinese yield spreads over G7 fell sharply and have stayed negative).
Unlike other major economies, the Chinese economy did not rebound in 2022 after remaining in Covid lockdowns. With low inflation, this meant that China could avoid monetary tightening, unlike G7 economies, which implemented aggressive policy tightening to control inflation. Commensurate with diverging monetary policies was the weaker Chinese yuan relative to the US dollar, which was another factor for capital outflows.
Missed opportunity for foreign investors in 2022?
Despite reduced foreign participation, Chinese government bonds have shown resilience and outperformed most of their global peers. Chart 3a shows Chinese government bonds topped the list for positive returns in local currency terms in 2022, and made the smallest losses in US dollar terms, only lagging short US Treasuries.
More recently, the performance since January (Chart 3b) suggests that Chinese government bonds have continued to benefit from an easing in monetary policy (e.g., liquidity support from the PBoC via the reverse repos and medium-term loan facilities, and the cut in reserve requirement ratio), delivering positive returns in both local currency and US dollar terms. With Chinese inflation at less than 1% y/y, the PBoC is expected to maintain its dovish policy stance for some time, and the environment could be ripe for renewed foreign investor participation. The ongoing US debt ceiling crisis, risk of a surge in US Treasury Bill issuance should a debt ceiling deal be reached, and Fed concerns about US core inflation all argue against an early Fed policy pivot to cut rates. In addition, the Chinese government bond market has a low correlation with G7 government bonds, and attractions as a fixed income portfolio diversifier as a result.
After a brutal 2022, a sweet spot for Chinese US dollar high yield bonds?
The move away from Chinese onshore bonds by overseas investors was also evident in the offshore dollar high yield bond market, where performance was hit by defaults of property developers during 2022, and a loss of confidence in the sector. As a result, Chinese high yield dollar credits lost almost 30% in 2022, despite a strong comeback in Q4, helped by the 16-point relief package for the property sector. In addition to a loss of confidence as property bond issuers continued to restructure their debt, US dollar bond investors also feared borrowers would opt to pay back their onshore RMB-denominated debt before their US dollar debt, increasing uncertainty over dollar bond repayments.
Consequently, Chinese $ high yield bond spreads significantly widened between October through early November 2022 (Chart 4). Since then, they have eased and narrowed by about 4400bps from the peak in Q4 2022, after the combination of relief measures and the country’s easing of Covid restrictions prompted a strong rally. More recently, spreads have widened to 5500bp on renewed risk aversion and are higher than pre-Covid levels.
But wider credit spreads, implying lower bond valuations currently, may suggest higher future investment returns, with low bond prices strongly correlated with higher future returns for risky assets like high yield bonds, as discussed in our Valuation Matters paper[1].
Facts and fiction about the Chinese corporate debt markets onshore and offshore
A careful look at the broader Chinese corporate bond market shows that bonds issued by property developers account for just 2.1% of the overall domestic corporate bond market and 6.8% in the US dollar corporate bond market. The higher property weighting in the US dollar corporates is mainly driven by the sector’s significant share of the overall high yield $ market (almost 37% in high yield vs 4% in investment grade). But it’s worth noting that high yield rated bonds (market value of $21.8 billion) account for around 7% of the entire Chinese US dollar corporate universe (market value of $298.4 billion).
So, several factors may cause a recovery in foreign participation in Chinese onshore bond market. These include low inflation, supportive monetary policies, low correlation with G7 bond markets, regulatory reform by the Chinese government in opening its financial markets to overseas investors and an improving economic outlook for the property sector. Although earnings and fundamentals dominate the property bond market in the long run, some further regulatory support for the property sector could help the market in the near term.
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[1]Valuation matters: US high yield and US equities | FTSE Russell.
[1] Source: China Bond Information Network--Monthly Bulletin of Statistics. Foreign institutional investors can trade in the CIBM via three channels, 1) CIBM Direct, accounting for the largest share in bond custodian, 2) Bond Connect northbound trading, and 3) Qualified Foreign Institutional Investor (QFII) and RMB Qualified Foreign Institutional Investor (RQFII).
[2]Company Introduction | Bond Connect (chinabondconnect.com).
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