Investors ramp up exposure to Chinese bonds

The economy-toppling health crisis of 2020 has only accentuated the nascent charms of Chinese government bonds in the eyes of overseas investors, industry veterans say.

As the year began, inflows had been poised to rise on the back of improving market access, benchmark bond index inclusions and a respite in U.S.-China trade tensions, but momentum kicked into a higher gear as the country's economy led the way globally in fighting through coronavirus-related challenges.

The market context evolved materially this year, in a way that bolstered the case for Chinese government bonds, said Paras Anand, Singapore-based chief investment officer, Asia-Pacific, with Fidelity International. The firm had $611.4 billion in assets under management as of Sept. 30.

In the face of a "substantial test" for China's economy this year, "we've seen currency stability … successful management of the pandemic (and) a return of economic activity," giving investors a greater degree of confidence and supporting arguments in favor of a "meaningful" portfolio response, he added.

Chinese bonds "are getting a lot of positive attention due to how they've been proven to be a diversifier in portfolios through the pandemic," agreed Jean de Kock, Singapore-based fixed-income manager research specialist with Mercer Investment Solutions (Singapore) Pte. Ltd. Yields that look attractive even on a hedged basis are adding to their attraction, he added.

"Without doubt, the pace at which inflows have increased this year is ... faster than what we would have anticipated at the start of the year" — strong, sustained, pretty broad-based, said Prashant Singh, a Singapore-based senior portfolio manager of emerging markets debt with Neuberger Berman Group LLC.

Mr. Singh said China Central Depository & Clearing Co./Shanghai Clearing House data show flows into Chinese bonds this year — predominantly government and quasi-official bonds — at more than 800 billion yuan ($121.1 billion), up 76% from the previous year. Of that total, he estimated roughly 650 billion yuan were passive flows and 150 billion yuan active. A spokesman for the firm, which has AUM of $356 billion, declined to comment on Neuberger's exposure to Chinese government bonds.Foreign investors' share of China's $9.2 trillion onshore government bond market rose to 9.5% at the end of October from 7.9% at the close of 2018, and a structural pickup in interest should lift that total above 15% over the long term, said Jason Pang, a Hong Kong-based fixed-income portfolio manager with J.P. Morgan Asset Management.

This year, foreign holdings of the government bond market's policy bank bond segment — covering $2.6 trillion in paper issued by the China Development Bank, the Agricultural Development Bank of China and the Export-Import Bank of China — have posted even stronger growth, more than doubling to 5% at the end of October from 2.2% at the close of 2018, Mr. Pang said. That pick up in foreign interest points to foreign investors' growing familiarity and comfort with the mainland bond market, he said. The manager reported assets under management of $2.60 trillion as of Sept. 30. Details on the firm's exposure to Chinese bonds wasn't immediately available.

That Chinese government bonds are garnering interest now is "not surprising," said Mr. Singh, noting that operationally it has become easier to access the market while yields of more than 3% remain alluring when compared to 10-year Treasury yields below 1% and negative yields for German and Japanese bonds.

Kheng Siang Ng, Singapore-based Asia-Pacific head of fixed income with State Street Global Advisors, said that as U.S.-China trade ties went from bad to worse late last year, "we did see some so-called postponement into China, at least for some of our clients," but this year, with investors more willing to anticipate less cataclysmic outcomes, "we started to see, at least more recently, they're taking action to invest," he said. SSGA had AUM of $3.15 trillion as of Sept. 30.

Mr. Anand said the broader contrast between how China and the U.S. are managing their economies this year should promote further interest in China's bonds. "You needed a crisis" to reveal the stark differences in economic strategy, he said.

The U.S. decision to largely "monetize the crisis" crushed U.S. bond yields while short-circuiting an almost decade-long bull run by the U.S. dollar. China's decision not to monetize the crisis left the country with a functioning bond market, capable of offering diversification benefits for investors' portfolios, a well-supported currency and a relatively strong medium-term growth outlook, he said.

Chinese government bonds are one of a handful of less-familiar asset classes that investors facing a "lower-for-longer environment" are exploring now, said Andy Sparks, New York-based managing director and head of portfolio management research with MSCI Inc.

Mr. Sparks said his firm's risk models showed a 10% allocation to local currency Chinese government bonds would lower the risk of a portfolio of developed market sovereign bonds by 7%, although the model is silent on what the impact on performance would be.

Analysts say the promise of attractive returns from a combination of higher yields and a strengthening yuan are swelling the ranks of investors moving into Chinese government bonds now or planning to do so.

"People are looking for the right opportunity to allocate," a very different environment from two years ago, when they were more likely to look for reasons to reject Chinese bonds, said Edmund Goh, Shanghai-based investment director, fixed income-Asia, with Aberdeen Standard Investments (Asia) Ltd.

Today, not investing in China has become "an active decision … and if you decide not to, you have to explain," Mr. Goh said.

Aberdeen Standard's exposure to local currency Chinese bonds doubled to 2 billion yuan as of September from 1 billion yuan as of March 2018, all the result of active allocation decisions, he said.

A growing number of money managers who have yet to invest in Chinese bonds say they're increasingly open to doing so in the future.

"Accessibility and liquidity were the two main challenges, historically, preventing us from investing in Chinese government bonds. As the market has evolved and continues to mature, we feel increasingly comfortable investing in these securities," said Brian Giuliano, Philadelphia-based vice president, portfolio management, with Brandywine Global Investment Management LLC, which has $62 billion in assets under management.

"Although we don't have an allocation currently, considering the relatively higher yield on CGBs, the defensive characteristics of these bonds, and China's growing sphere of influence, I can envision us allocating to these securities when their relative valuations and fundamentals align with our disciplined process," Mr. Giuliano said in an email.

Andrew Jackson, London-based head of fixed income with Federated Hermes Inc., expressed similar sentiments in a recent market presentation. While "we have yet to go into CGBs," the liberalization of Chinese markets in the last few years has been considerable, he said.

To get yields in China of a little more than 3% for a safe haven asset in a world devoid of yield is something that's "really hard to do," said Mr. Jackson, adding "I think you're going to see us increasingly use CGBs in the next few years." The firm has a total $614.8 billion in assets under management.

Meanwhile, Troy Rieck, chief investment officer of A$13 billion, Brisbane-based LGIAsuper, said Chinese government bonds are one of a number of potential investments to look into on his "to-do" list now – "an interesting investment proposition, almost a half-way house between G-7 government bonds and local currency emerging market debt," offering both higher yields than their G-7 counterparts and some potential to deliver positive returns in risk-off environments.

Participation is clearly on an upswing, but when it comes to having the full range of tools investors seek to trade and hedge risks more efficiently, "we're still in the early innings" of opening up this market, said Leonard Kwan, a Hong Kong-based vice president and emerging markets fixed income portfolio manager with T. Rowe Price Group Inc.

Tools needed to hedge onshore currency exposures, interest rate exposures, bond futures "are probably on the way to being delivered" but it's a process that will span years if not a decade or more, he said.

Fidelity's Mr. Anand said his team is bringing up Chinese government bonds with investors in the context of broader discussions of whether they should be looking at the Asia-Pacific region from a tactical viewpoint or a strategic one.

"Many clients historically have looked at Asian markets as a gear play on global growth," he noted. But "we're trying to argue the fundamental aspects and attractions of these markets" should make them figure more prominently in client portfolios, he said.