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The investment case for RMB denominated sovereign debt

22nd October 2020

The RMB bond market is today the world’s second largest fixed income asset class and with many recent new innovations such as Bond Connect, it has seen its accessibility by foreign investors increase substantially in recent months. With the yield differential of RMB bonds against other regional markets at an all-time high combined with a positive technical tailwind as more and more RMB bonds are being added to global benchmark indices, China’s domestic bonds asset class is a highly attractive investment proposition at present. JK Capital is active in RMB-denominated bonds through our existing fixed income portfolios and our Bond Connect license. As such we are well positioned to scale up dedicated investment solutions in this space.

The investment rationale

To consider an investment in the RMB domestic bond market one has to focus on five key parameters.

1.          The absolute yield and how it compares to alternative global asset classes

2.          The trajectory of domestic interest rates in China

3.          The outlook for the Chinese currency, the RMB, and the hedging costs against the investor’s base currency

4.          The value and outlook for Chinese domestic bond credit spreads

5.          The liquidity of the various segments of the market

Absolute Yield

In the current low interest rate environment, perhaps the most attractive feature of the RMB bond market is the current level of yields. As of 20th October 2020, the 10-year China sovereign domestic bond offered a yield of 3.21%. This gives a yield premium of 244bps over 10-year US Treasuries, which is the highest spread between Chinese and US government bonds since records began. Against the 10-year German bund, the yield pick-up is even more pronounced at 384bps. This level of carry provides an important buffer in the face of an uncertain macro-economic future and, at the very least, should provide a high level of stability for RMB bond returns in the medium term.

Trajectory of Domestic Rates

Clearly there are reasons for the bond yield differential to hit record highs. While China’s domestic rates have been at a premium to Western economies for over 10 years, undoubtedly the recent COVID-19 crisis has exacerbated the bond yield gap. Although it is commonly believed the virus outbreak originated in the Central China province of Hubei, it is equally clear that China, alongside other North Asian countries have been vastly more successful than other parts of the world in containing the outbreak. Consequently China has been able to maintain economic activity for most of 2020 without any prolonged shutdown of the entire country. As we enter the tenth month since the COVID crisis began, the Chinese domestic economy is back to running at almost full capacity.

As a result, the Chinese and Western governments have adopted highly contrasting approaches to managing their economies, most notably with the US and the Eurozone opting for massive fiscal and monetary stimulus while China, highly cognizant of problems caused by previous rounds of aggressive financial stimulus, has decided to take a much more cautious approach with little in the way of monetary easing. In some outperforming areas of the economy such as real estate, the Chinese government has actually resorted to policy tightening. These fundamental distinctions are clearly behind the recent shift in yields with long dated Chinese government bonds trending higher in the 2H20, reflecting a heavy new issue pipeline in recent months while US and Europe on the other hand are seeing long dated rates being capped by large amounts of Quantitative Easing and central banks all signaling a highly dovish stance.

The long term outlook remains highly unpredictable as it is clouded by uncertainty surrounding the trend of the COVID outbreak, by ambiguity surrounding the timing of a possible vaccine as well as by political upheaval in the US. It is expected that new issue supply has reached its peak in China and that the fourth quarter could see a period of stability for the domestic market. Most strategists are forecasting a year-end Chinese Government Bond 10-year yield target of 3.0% (vs 3.2% now). We expect stability at the long end of the RMB curve for the medium term and we like the 5 to 10-year tenors on this basis.

RMB trajectory and current hedging costs

A major implication of the sharp fall in US interest rates and of massive fiscal stimulus in the US has been a significant weakening of the USD in 2020. Since the start of 2020, the RMB has gained 4.0% against the greenback, most of those gains coming in the past 3-4 months. For foreign bond investors holding unhedged exposures to the RMB bond market this has been a critical factor underpinning their returns given it has offset the recent rises in domestic yields. Indeed, investing in a 10-year China Sovereign RMB bond in the 3 months since August 1st 2020 would have returned -1.2% in RMB terms but +4.0% in USD terms and +4.4% in EUR terms.

On the flip side the large interest rate differential and high level of FX volatility have caused the RMB currency hedging costs to increase substantially. Today the cost of a 12-month forward RMB FX hedge into USD is 2.5%. To hedge the RMB into EUR costs a significant 3.4%. In other words, currency hedging more than wipes out the yield advantage of holding domestic bonds directly. Therefore holding RMB bonds on a hedged basis only makes sense, in our view, if the investor has a strong reason to believe the RMB bond yields will be declining going forward. As we stated previously the current consensus outlook is for a modest decline in yields up to year-end although the longer term outlook is a lot less certain.

The market outlook for the currency is more positive with the majority of strategists forecasting an appreciation of the RMB over the next 1-2 years, and on this basis it remains our preference to hold RMB bonds on an unhedged basis. For those required to hedge their currency we believe a direct holding of USD or EUR denominated China sovereign bonds provides a better investment given these still provide some positive carry on their investment as shown in figure 1.  

Chinese domestic bond credit spreads

Another way to enhance yields in the RMB market is to move into credit instruments that provide a yield pick-up for a modest increase in credit risk. The most popular trade in this regard is to buy policy banks paper such as China Development Bank (CDB) and EXIM China which are 100% owned entities effectively guaranteed by the government. Not only do these entities offer an attractive (~50bps) yield pick up over the sovereign curve, but given the fact that they are regular issuers in the market they exhibit a similar liquidity profile as sovereign debt.

Investing in AAA rated State-Owned Enterprises can add a further 50bps yield to the returns although these tend to be less liquid instruments. In our existing fund we like the policy banks given their good balance of yield, credit worthiness and liquidity.

Market Liquidity

Other large segments of the RMB market include Negotiable Certificates of Deposits (or NCDs i.e. short term bank paper), Local Government Bonds and Corporate debt (including high yield issues). NCD’s have seen increasing interest from foreign investors given that their short tenors make them ideal “buy and hold trades”. Local government paper and High Yield corporate debt however remain quite illiquid. Given the poor level of financial disclosure onshore in these segments they are not yet well suited for foreign investors at present, in our view. For investors who wish to move down the credit curve into BBB or BB rated issuers we still strongly prefer the Chinese USD bond market which offers better liquidity and transparency. Given the recent declines in EUR hedging costs, the Chinese USD bond market can also be an attractive prospect for EUR based investors.

Figure 1: China Government Bond yield prospects in CNY, EUR, USD

Source: Bloomberg

The information contained herein is issued by JK Capital Management Limited. To the best of its knowledge and belief, JK Capital Management Limited considers the information contained herein is accurate as at the date of publication. However, no warranty is given on the accuracy, adequacy or completeness of the information. Neither JK Capital Management Limited, nor its affiliates, directors and employees assumes any liabilities (including any third party liability) in respect of any errors or omissions on this report. Under no circumstances should this information or any part of it be copied, reproduced or redistributed.

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