Beginning in April, Bloomberg will add local currency denominated Chinese bonds to its Bloomberg Barclays Global Aggregate Index. Chinese government bonds (CGBs) and securities issued by China’s policy banks will eventually account for 5.5 percent of the $53.7 trillion index, one of the most widely followed benchmarks for global bond managers. This will make China’s currency weighting the fourth most important in the index and put its bond market on a par with Japan’s.
Outperforming Equity and Currency Markets
Most Chinese assets have had a torrid time of late. The Shanghai Composite (equity) Index is down 24 percent over the past year and the renminbi has fallen by 6.8 percent against the U.S. dollar. Government bonds, however, have rallied. The 10-year benchmark bond is 77 basis points lower than a year ago.
One explanation is that investors have been positioning themselves ahead of April’s index inclusion. China only fully opened its $12 trillion onshore interbank bond market to foreign investors in February 2016. In March 2018, the time of the Bloomberg announcement, international portfolio managers owned just 7 percent of CGBs and a paltry 2 percent of local credit. Since then they have been playing catch up.
According to Morgan Stanley, foreign investors poured almost as much money into CGBs in 2018 as the entire stock of overseas investment in any other emerging market sovereign credit (approximately $100 billion versus the $115 billion held in Brazilian government debt). That weight of money is certainly enough to drive a rally.
Follow the Index
From a portfolio and risk management perspective it is also entirely rational. Passive managers have no choice but to follow the index. Active managers can make a decision either way. But a 5.5 percent weighting is significant and holding a zero weighting, with the resulting tracking error, is a bold asset allocation call. Accruing a position over time is far more prudent than trying to scramble to get to the appropriate weighting when Bloomberg pulls the trigger in April.
Some commentators believe the unprecedented inflows in 2018 mean that the Chinese government bond rally has now run its course. The 10-year CGB briefly flirted with the 3 percent level earlier this year and is now at 3.15 percent. However, ownership data suggests asset managers were probably not the biggest foreign buyers of CGBs last year. They still account for a mere 6 percent of ownership with 76 percent owned by central banks and other official institutions and the balance in the hands of overseas banks.
Central bank buying reflects a development that precedes Bloomberg’s index decision: China’s inclusion in the International Monetary Fund’s SDR basket of official reserve currencies in October 2016 with a 10.6 percent weighting. Asset managers have a lot more scope to add to their positions. Whether they do or not will be driven by fundamentals, valuations and the role CGBs may play in future global bond portfolios.
Last year’s rally arguably leaves valuations looking a little stretched. There have only been two periods during which CGBs have traded below 3 percent: 2008 in the aftermath of the global financial crisis and 2016 when developed market bond yields were being artificially suppressed by quantitative easing and investors were desperately searching for low risk yield.
The fundamentals are still supportive for CGBs. China is one of the few significant economies that is still loosening policy. The required reserve ratio dropped by 0.5 percent on Jan. 15 and a further 0.5 percent on Jan. 25. This will release 800 billion yuan ($116 billion) of liquidity according to the People’s Bank of China. With latest data suggesting a continuing economic slowdown, these are unlikely to be the last such moves.
A Place in Global Portfolios?
More intriguing is the role CGBs may come to play in global bond portfolios. For most emerging market investors, the yields are lower than they are used to and unlikely to generate the returns their clients expect. But for developed market managers 10-year CGBs still offer a significant yield pick-up. For example, Italian 10-year bonds yield 2.7 percent even though China has a better credit rating.
During bouts of risk aversion toward emerging market (EM) bonds (2016, for example) contagion has been rapid and selling indiscriminate. CGBs may offer an EM safe-haven in a reserve currency. The Chinese also have the fiscal and monetary scope to put in place countercyclical measures during periods when the U.S. Federal Reserve is tightening, which has typically been bad news for other EM assets.
Index inclusion is undoubtedly important. It marks a further step forward in China’s attempts to internationalize its markets and play a role in finance on par with its economic significance.