“In the longer term, as the development of the onshore bond market continues while the RMB gradually reaches a global reserve currency status, foreign investors’ desire to gain RMB exposure should lead to an increase in demand for RMB-denominated bonds,” wrote Ben Luk, global market strategist and Peggy Chen, market analyst, in a recent note.
“[This] would likely trigger a steady ongoing asset reallocation from traditional developed market bonds into the Chinese bond market.”
Additionally, onshore bonds have been offering higher yield than many other major developed market sovereign bonds, even in the current low interest rate environment.
Moreover, significant foreign reserves and a sizeable current account surplus bode well for an upgrade in China’s credit ratings.
China’s sovereign rating has improved from BBB (non-investment grade) to AA- (investment grade) over the last 10 years, according to Standard & Poor’s, while many developed countries have gone through tough downgrading cycles.
Volatility has also been comparatively lower than other sovereign bonds with similar credit ratings, according to the research note. A steady yield and RMB appreciation have made Chinese bonds “one of the more attractive risk-adjustment-based asset classes for investors to consider in their portfolio”.
Source: Bloomberg, J.P. Morgan Asset Management. Data reflect most recently available as of 31/7/15. All indices in USD terms for the period of 31 /7/2005 to 31/7/2015 unless stated otherwise.
Due to different monetary cycles, the historical correlation between China’s sovereign bond yields and other developed markets’ government bond yields has also been low.
Low foreign intake
China is currently the world’s third largest bond market, trailing the US and Japan.
Since 1997, China’s bond market has had a compound annual growth rate of 37.9% to reach $5.3trn at the end of the first quarter.
But foreign ownership of Chinese bonds has remained minimal. At around 2%, foreign ownership in China’s bond market is low compared to other Asian countries such as Korea (11%), Thailand (16%), Malaysia (31%) and Indonesia (40%).
“We believe this is about to change as further development of the onshore bond market will benefit the economy and widen investors’ opportunities.”
Creating a robust market
China is still an emerging economy and bond markets are still at a very early stage. As a result, concerns in terms of liquidity, credit and default risks prevail. China needs to address these in order to create a robust bond market, the report said.
China’s total debt-to-GDP ratio of 217% remains moderate compared to most of the developed world, but investors have continually been worried about debt expansion. From 2007 to 2014, debt increased 87%, making China one of the fastest debt accumulating nations.
The researchers believe the municipal bond market will help reduce systematic risk in the economy.
“[T]he Ministry of Finance has given local governments permission to issue up to RMB2trn ($0.3trn) worth of bonds to replace RMB1.86trn worth of debt that is maturing this year.
“By switching bank loans to municipal bonds, this will extend the maturities of existing debt and lower overall borrowing costs for local governments, while the central government can benefit from greater transparency of the debt situation in China.”
The top RMB fixed income funds in the Hong Kong universe over the trailing three years: