Chinese bonds seen as haven in a down economy

Growing fears of a global recession are set to boost the attractions of the relatively high yields on offer now for Chinese government bonds.

Those bonds' phased inclusion since April in the Bloomberg Barclays Global Aggregate Bond index has been boosting inflows this year, but now their potential charms in a softening global economy — including positive real and nominal returns, considerable liquidity and solid investment-grade ratings — could fuel further momentum, analysts said.

A global economic downturn over the coming 12 to 18 months would "accelerate the attractiveness" of Chinese government bonds, said Harvey Bradley, a London-based portfolio manager with Insight Investment Management Ltd.

For now, while Insight's base-case for the global economy calls for below-trend growth rather than a recession, the firm is tweaking its allocations to take advantage of a relatively steep yield curve for Chinese government bonds, extending the duration of its holdings to seven years and more from two-year to five-year paper earlier in the year, said Mr. Bradley.

The latest statistics from China Central Depository and Clearing Co. Ltd. show allocations by overseas institutional investors to all Chinese bonds reaching a record 2.02 trillion yuan ($282 billion) as of July 31, up 3.2% from the previous month and up 25% from the year before. Over the four months since Chinese bonds began entering the Bloomberg Barclays Global Agg at a clip of roughly 30 basis points of that index per month, the value of foreign investors' holdings of Chinese bonds jumped by 14%, double the 7% gain for the prior four months through March 31.

Meanwhile, the number of investors registered with China's 2-year-old Bond Connect program, which allows investors based in Hong Kong to freely trade mainland bonds, stood at 1,134 as of July 31, up from 1,038 a month before and 391 a year earlier.

Those numbers suggest the "mainstreaming" of Chinese bonds for institutional investors globally is well advanced and transitioning now to a "value proposition" phase, said Wilfred Wee, Singapore-based portfolio manager of Investec Asset Management's $54 million All China Bond strategy.

The relatively high, positive yields Chinese bonds offer now are "certainly a charm," while the low correlation with U.S. Treasuries, the other huge market now sporting positive yields, is a further reason to be "looking at a China bond allocation now," Mr. Wee said.

Mr. Bradley said Insight Investments has overweighted its exposure to Chinese bonds this year for accounts where it had leeway to do so.

Should growing clouds on the economic horizon lead to yet another round of monetary easing — on top of the extraordinary measures deployed by major central banks following the global financial crisis — China's $13 trillion government bond market would have more room to let yields fall than other major markets.

The 3.071% yield on China's 10-year bond as of Aug. 26 was roughly double the 10-year Treasury's 1.528% yield. The U.K.'s 10-year gilt, meanwhile, was offering a 48.2 basis point yield, while bonds with the same tenure in Japan and Germany offered negative yields of 27.5 basis points and 66.4 basis points, respectively. More recently, weak Chinese and German data, announced Aug. 14, have increased pessimism about the global economic outlook, sending Wall Street into an 800-point tailspin that day. In ensuing weeks, markets have been unsettled by an escalation of President Donald Trump's confrontational trade tactics with China, which analysts say have raised the odds of a global recession over the coming 12 to 18 months.

Whether Chinese bonds would be the belle of the ball in such a pessimistic market scenario would depend, to a large extent, on how much bonds already weighed down by negative yields could push further into negative territory.

The yield on global developed market bond indexes has dropped 200 basis points "every time you've had a … global recession," said Hayden Briscoe, UBS Asset Management's Hong Kong-based head of fixed income, Asia Pacific. But with a large swath of those bonds now trading near or below zero, a fall of that scale is hard to conceive "unless you believe that bonds are going to -200 (basis points), or -300 bps in the case of bunds."

That leaves asset owners today with no satisfying answer to the question of whether, in the event of a nasty global risk-off episode, they have the right safe assets, in the right size, to cushion the potential fall in value of their risk assets. "I'd say they haven't got them today," Mr. Briscoe said.

The biggest question for investors now is "where do I turn for defensiveness," agreed George Efstathopoulos, Hong Kong-based portfolio manager of Fidelity International's $9 billion Global Multi Asset Income Fund. "For us, defensiveness means U.S. government bonds" and U.S. high-quality investment-grade bonds, but also China government bonds — with a current allocation of 3% to 3½% - together with U.K. and Australian government bonds.

A combination of U.S. and Chinese bonds now would provide far better outcomes than the supposedly diversified exposures offered by the global aggregate index, Mr. Briscoe said.

Some market veterans — while conceding Chinese bonds have a chance to shine as markets with negative yields offer less downside protection — warn the recent flare-up of U.S.-China trade tensions could complicate matters.

A 3% yield, a liquid market and a solid credit rating should make China an attractive choice for investors hunting for income and a "hedge for left-tail events," said Stephen Chang, a Hong Kong-based executive vice president and portfolio manager with Pacific Investment Management Co. But trade war uncertainties, threatening China's capital flows and current account balance, "could potentially disrupt the outlook," he said.

For the post-global financial crisis period, however, it was capital gains on sovereign bond holdings, reflecting the rise in bond prices that effectively pushed yields lower, that drove returns for institutional investors.

The quantitative easing programs of the past decade, with central banks in the U.S., Europe and Japan buying huge quantities of bonds to lower yields and boost their economies, was "one massive capital gains-fest," said Jan Dehn, London-based global head of research with Ashmore Group PLC.

During that period, despite the relatively high yields on offer from the emerging markets bond segment Ashmore focuses on, clients pulled roughly a third of the firm's assets in pursuit of the "unprecedented opportunity" quantitative easing was serving up in developed markets, Mr. Dehn said.

At present, however, the yield on offer from emerging markets bonds looks to be more of a sure thing than an increasingly risky bet on continued capital gains, said Mr. Dehn. While all the data point to recession, developed market bonds are pricing in way more cuts than central banks have offered, and investors would need to see a particularly bad recession to continue to make money now in developed market bonds, he added.

Ashmore has seen its assets under management surge over the past three years to $92 billion from $48 billion, he said. More than 85% of Ashmore's assets are invested in emerging markets debt.

UBS Asset Management's Mr. Briscoe said a slowing global economy could pose risks for the emerging markets bond segment if, for example, falling energy and mineral prices leaves those markets under pressure. The risk-reward trade-off for a select portfolio of developed market bonds might prove more compelling than that offered by higher risk segments like credit and emerging markets, he said.

Demand for Chinese bonds could grow regardless of whether emerging markets bonds or developed market bonds deliver higher returns.

"China sits in an interesting place ... a crossover name," noted Insight Investment's Mr. Bradley. Historically, China — whose bonds account for roughly 50% of the emerging market bond universe — has been looked at as an emerging market but it's moving now into the developed market universe, with its inclusion in Bloomberg Barclays, he said.

And with positive real and nominal yields, those bonds have a role to play in both segments.

Calling the current moment in economic policy the hardest to predict or fathom in his 28-year career, Mr. Briscoe said a sensible approach amid a critical mass of uncertainties is to have "duration in your portfolio wherever you can find it with some yield — getting ready for a slowdown."

Investec's Mr. Wee said with China due to become the fourth biggest component of the Bloomberg Barclays Aggregate Bond index by the middle of 2020, edging out the U.K., U.S. investors increasingly should hedge by complementing their holdings of U.S. bonds with some exposure to Chinese bonds.

Mr. Briscoe likewise recommended investors focus on exposures to U.S. and Chinese bonds — positioned to benefit as U.S. rates continue falling and Chinese rates begin to drop as well by the end of the year.