New opportunities in Chinese bonds

China’s local-currency bond market is opening up to global investors. Scott explains the investing implications.

China’s local-currency bond market is opening up to global investors. The Bloomberg Barclays Global Aggregate Index begins including yuan-denominated bonds this month, automatically adding exposure to such bonds for index investors. We favor maintaining such passive exposure and preparing to invest more.

China and Developed Markets bond yields (2005-2019)

The inclusion of local-currency government and policy bank securities into the global bond market benchmark index is set to gradually occur over a 20-month period. Those passively invested in that index will, by default, add Chinese bond exposure to their holdings – which we view as a positive. Local-currency Chinese bonds are set to make up roughly 6% of the global fixed income benchmark when the phase-in is complete. At that stage, China’s yuan currency will be the fourth-largest component in the index, behind the U.S. dollar, euro and Japanese yen. The chart above shows one reason we advocate investors maintain the inclusion exposure: Local-currency Chinese bond yields this decade have been materially higher than the average yields of the developed market bonds that make up the majority of the global bond index. See the top line in the chart above.

A very good place to start

We see China becoming a growth turnaround story this year, as policy makers ease fiscal and monetary policies and market fears of a U.S.-China trade war dissipate (see our Q2 Global investment outlook). Improvements in the domestic economy should result in rising yields and a stable or appreciating yuan currency. Christian Carrillo of BlackRock’s Asia Pacific fixed income team sees the higher yields of Chinese bonds creating a tactical opportunity to add additional exposure in the future. His team estimates the fair value yield of 10-year Chinese government bonds will rise slightly in the second half amid positive economic data surprises and stabilizing inflation, but actual yields may rise more. Chinese bond prices may decline a bit as yields rise, but investors maintaining exposure stand to benefit from both relatively high income and potential currency gains.

China’s bond market has been dominated by domestic investors, and offers diversification benefits as a result. The correlation between Chinese bond and U.S. Treasury prices has been close to zero over the past five years. This benefit may diminish over time as foreign investors’ ownership share of the market increases.

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What are the other risks and challenges?

We believe investors who hedge their currency exposure should take a patient approach toward Chinese bonds, as hedging costs currently are significant. This could improve over time as affordable hedging instruments become available. Liquidity is also a concern, particularly for investors with shorter-term horizons. The domestic Chinese investor traditionally has had a “buy and hold” approach to investing. As more foreign investors gain access to this market and trading begins between onshore and offshore players, liquidity should improve.

Bottom line

China’s bond market is the world’s third-largest, with about $13 trillion in outstanding bonds. We believe the market’s size, attractive yields and diversification benefits mean it cannot be ignored, similar to our view on China’s domestic equity market. We see China’s inclusion in global bond benchmarks as a key event. Understanding the market is key. We believe maintaining automatic exposures and preparing to invest more is a very good place to start.

Scott Thiel is BlackRock’s chief fixed income strategist, and a member of the BlackRock Investment Institute. He is a regular contributor to The Blog.

Investing involves risks, including possible loss of principal.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

International investing involves special risks including, but not limited to currency fluctuations, illiquidity and volatility. These risks may be heightened for investments in emerging markets.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of April 2019 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

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