Rising appeal of China bonds has its limits

Foreign investors are buying more onshore Chinese debt, but currency worries remain a drag on the market.

Foreign buying of Chinese onshore bonds, principally government bonds, has risen sharply in the last two months thanks to the renminbi's more stable performance and the opening of Bond Connect on July 3.

But it's still at very low levels, given the $9 trillion-plus size of the market - and will remain so until a variety of functional shortcomings are addressed. In a two-part article, FinanceAsia's sister title AsianInvestor is examining some of these issues.

Foreign holdings of Chinese onshore government bonds expanded by 8.4% in July to Rmb486.8 billion ($72 billion), after a 4.7% increase in June, China Central Depository and Clearing data shows. That follows a more muted improvement in the first five months of 2017, when they rose by just over Rmb5 billion.

The pickup in foreign demand for Chinese bonds has coincided with a stronger renminbi, which has firmed by 2.5% against the dollar since June 26, accounting for the bulk of the currency's appreciation so far this year.

The extent to which higher bond inflows have helped to support the renminbi or a more favourable outlook for the currency has helped to draw in more bond inflows is unclear.

What seems clearer though is that foreign holders of onshore Chinese bonds are faced with currency risks as well as credit risks, which is one reason why there is a limit to the amount available to foreign investors. 

That's because most foreign investment in renminbi bonds is done on an unhedged basis due to high hedging costs, said Ben Sy, Asia head of fixed income, FX and commodities at JP Morgan Private Bank. Hedging costs currently charged by banks are high and the yields Chinese bonds offer after hedging are not attractive. 

UBS Wealth Management in a July 11 research note estimated that 10-year Chinese government bonds paid just 1.4% on a fully hedged dollar basis. Comparable US Treasuries currently yield around 2.24% while China 10-year government bonds are yielding 3.676% on an unhedged basis.

As of now, most investors are not comfortable with renminbi risk, said Aaron Costello, Beijing-based managing director on Cambridge Associates’ global investment research team.

For that to change, hedging the currency would need to get cheaper and easier, Costello said. 

Renminbi outlook

The outlook for the renminbi remains uncertain with expert opinion mixed. The currency has gained recently but that is as much a reflection of US dollar weakness as renminbi strength, given how much the greenback has weakened against other currencies in recent weeks. But it may also reflect a desire by the Chinese authorities to maintain a stable appearance ahead of the next Communist Party Congress, Costello said.

“We are still somewhat bearish about [the renminbi] versus US dollar to about 6.95 in mid-2018,” JP Morgan’s Sy said. The currency traded at Rmb6.66 to the dollar on Thursday having ended 2016 at Rmb6.94.

Some Chinese managers are more bullish. Suzie Xie, the Shanghai-based head of international business of Ping An Asset Management, said her firm expected the renminbi to remain steady over the rest of this thanks to cyclical improvements in Chinese economy.

The longer-term outlook for the currency is harder to predict, she said, while anticipating structural improvements in the Chinese economy.

Han Tongli, Hong Kong-based founder and chief investment officer of DeepBlue Global Investment, said he believed the renminbi's rally against dollar will last into 2019. That’s why his portfolio is long on renminbi short-dated bonds such as six-to-12 month certificates of deposit.

Demand for Chinese fixed income would likely increase further if investors felt the dollar was about to enter a prolonged bear market. But it is too soon to make that call, especially if the Federal Reserve continues to raise interest rates, Costello said.

Also, since Chinese investors want to diversify their holdings overseas, the renminbi tends to come under some pressure any time China relaxes capital controls, because of the resultant increase in outflows. “This is a long-term headwind for the renminbi,” Costello said. 

Look out for the second in this two-part series, in which, among things, we touch upon Chinese credit ratings and Steve Berkley, global head of indices at Bloomberg, explains why his firm is not in a rush to include China in its main global index.

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