Recent selling pressures and rising US Treasury yields suggest diminishing prospects for China’s bonds. Could this be an ideal time to buy the dip?
Russia’s surprise invasion of Ukraine sent shockwaves through global markets, dampening risk sentiment and spurring a selloff in equities. And in the fixed-income markets, there appeared to be one unexpected casualty – China’s sovereign bonds.
Data shows that foreign investors slashed their holdings of Chinese government debt by RMB35 billion (about US$5.5 billion) in February 2022. This was the most significant reduction on record and the first decline since March 20211. As a result, the 10-year yield rose from 2.72% to 2.81% over the month2. The speed and scale of this pullback came as a surprise, and its actual cause has yet to be established.
Some market participants speculate that Russia’s central bank has been selling its Chinese sovereign bond holdings to generate cash. Others point toward the tightening monetary environment and rising US yields as the main culprit, noting that they now offer a much-reduced yield pickup3. Falling risk appetite in the wake of the invasion has also been fronted as another possible cause.
The real reason is likely to be a combination of all the above factors. However, as the selling pressure on Chinese sovereign bonds persists, the question is this: should investors join the herd and reduce their allocations to the asset class?
Our thoughts on this question can be summed up by a famous quote from Warren Buffett: “Be fearful when others are greedy, and greedy when others are fearful”4. Rather than trim allocations in the face of pressure, we believe there are strong arguments to invest in this asset class even as others flee.
Back in October 2021, the People’s Bank of China (PBOC) injected almost RMB1 trillion into the banking system in a matter of weeks5. Coming on the heels of a reserve ratio cut a few months earlier (July)6, this was taken as a clear sign that the bank was committed to a path of monetary easing. Accordingly, yields on Chinese sovereign debt started falling, and prices rose.
This supportive pattern persisted until late January 2022, whereby it reversed course. Since then, yields have been trending upwards (to 10 March 2022)7. This led to speculation that the rally in Chinese sovereign bonds was well and truly over8.
Some also argue that China’s easing cycle is likely to have just begun, creating a high likelihood that yields will fall – but this could only be a temporary reversal.
Consider that recent data shows cooling inflationary pressures in China, leaving space for further policy easing9 10 11. Furthermore, the PBOC’s first major easing move – slashing its mortgage lending, loan prime, and short-and medium-term lending rates – only happened in late January12. Subsequently, the central bank’s governor has gone on record, vowing to remain accommodative with monetary policy13.
Taken in combination, this data suggests more policy easing on the horizon and a good chance that yields will resume their downward trend in the near term. While this would indeed reduce the yield pickup offered by Chinese sovereign bonds, it could be more than compensated for with some prospects of capital appreciation. In general, even if Chinese sovereign bond yield do not decline in a large way, it can still act as safe harbour from capital losses of developed bond markets where yields are rising rapidly.
Potential capital appreciation aside, there are also the continued diversification benefits from holding Chinese sovereign bonds.
Their correlation with other fixed income markets is generally lower, as domestic factors hold a much greater influence over the market. The mere fact that China is easing while the US Federal Reserve is tightening – forcing many other central banks to raise rates to keep pace – is another testament to its diversification benefits. How many other markets have that capability? Add China’s debt-to-GDP ratio, which remains relatively low compared to developed territories14, to the mix, and you have a recipe for lower-risk diversification.
This is quite a contrast with the other options available in the Chinese corporate bond space, where risk appears to have been increasing. While the high-yield sector had naturally been a big attraction for investors given the low-yield environment, the yields have now reached the point of unsustainability. Average yields have breached 20% in the property sector – spurring refinancing risks even as more real-estate developers delay or default on their bond payments15 16.
There is also the ongoing inclusion of Chinese government debt to the FTSE Russell World Government Bond Index, which could result in about US$3.6 billion of inflows each month17. This provides a level of technical support that can help offset the selloff in foreign holdings – even if it is only temporary.
However, that may be a big ‘if’. While news headlines like to tout the February dip in foreign investor holdings as a “record selloff”, the truth is the RMB35 billion reduction was only a 1.4% decline, taking the total from RMB2.52 trillion to RMB2.48 trillion18. From that perspective, it is clear the selloff was much more modest than implied by the headlines.
We are presently confronted with a temporary dip in Chinese sovereign bond prices amid a backdrop of continued monetary easing and growing risks in other Chinese bond sectors. All these point toward a strong likelihood that yields will reverse their upward trend – creating a capital-appreciation opportunity for investors who seize the currently low prices. In short, is it time to buy the dip?
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Past performance is not a reliable indicator of future performance.
Diversification does not ensure a profit or guarantee against loss.
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