For asset owners looking to enhance fixed income yields, diversification and returns, and even to lower the volatility of their global bond portfolio, China is now a reality for their allocation.

Geoffrey Lunt,
senior product specialist,
Asian Fixed Income,
HSBC Global Asset Management

The April 2019 inclusion of renminbi-denominated bonds from the sovereign and some other government entities in the widely-followed Bloomberg Barclays Global Aggregate (BGA) Index, sets a ground-breaking shift in motion. “It has the potential to diversify portfolios and improve risk-adjusted returns,” explains Geoffrey Lunt, senior product specialist, Asian Fixed Income at HSBC Global Asset Management (HSBC AMG). “In effect, investing in Chinese bonds is likely to make portfolios more resilient.”

It is unusual for investors to be given access to such a deep and untapped opportunity. And sized at $12 trillion, China’s onshore bond market is the third-largest in the world after the US and Japan1. “Investors can now go long or short in China as well as take cross-market and curve positions, whereas before they may not have been able to invest in Chinese bonds at all,” adds Lunt. “There doesn’t seem to be a lot of downside to having this extra flexibility.”

A NEW WAY TO INVEST

With the index estimated to have tracking assets of $2.5 trillion, onshore Chinese bonds will be represented in a new way in global markets2.

For one thing, they will no longer be an off-benchmark option for index-following investors. In fact, they will have an expected allocation of 6.1% by November 2020, the end of the phased-in inclusion period3. By extension, HSBC AMG points out that these same investors who hold no fixed income allocation to onshore China will either be notably underweight this market or will need to consider shifting to an ex-China index alternative for a global bond product.

Fundamentally, the long-term diversification benefits of domestic China bonds offer what Lunt describes as the “silver bullet” that will drive new allocations.

Indeed, with global bond markets seemingly out of kilter with the broader macro cycle, the resulting uncertainty over whether fixed income is in a super-long cycle, or just long-overdue a crash, highlights the gains that portfolio diversity can bring.

Low yields in many developed markets coupled with prospects of rising interest rates in the coming years further bolster the case for greater exposure to China. “Looking at options for higher-yielding diversification in new markets makes more sense than ever,” adds Lunt.

He expects the characteristics of renminbi-denominated sovereign and policy bonds – of a good return profile plus low correlation to other markets – to continue. While it seems likely that the correlation of RMB bonds will increase over time as China becomes more integrated into the global economy, this is not likely in the short term. “In the meantime, the opportunity in China comes from its own unique domestic supply/demand dynamic for bonds plus its local rates cycle.”

CAREFUL PORTFOLIO PLANNING

At the moment, HSBC AMG sees solid valuations in China compared with other sovereign markets, such as the US, Germany and Japan. China’s fundamentals are also robust: low inflation, a stable currency with large reserves, a sovereign credit rated A+ by Standard & Poors and A1 by Moody’s (the same category as Ireland and Japan), and government efforts to cushion the domestic economy from current headwinds.

China’s entry into the index has also had state backing; it was only possible after the country’s regulators cleared roadblocks to inclusion, such as facilitating block trades and clarifying tax policies.

This explains expectations that index inclusion will play a significant role in China’s broader programme to open up its financial markets. "It will attract higher foreign participation in China’s bond market and positively advance RMB internationalisation," says Lunt.

He believes the best way to access this market is with a truly active or passive approach, with the least attractive route for investors being an index-hugging active approach. “Any problems within a sector will reflect on investors’ performance.”

Starting with sovereign and policy bonds in the BGA Index should also help address perceptions among some international investors that investing in China can be a risky option. “We think that they may not need as much sophisticated analysis as lower-quality credits do,” says Lunt.

At the same time, the fact that China’s bonds don’t conform to what some investors are used to elsewhere is part of the attraction. “This brings the diversification that an allocation to domestic bonds offers as a better way to add value to a portfolio,” he adds.

To learn more about China's market developments and our respective capabilities, please visit our China: open for business page.

1 Source: HSBC global Asset Management, March 2019.
2 Source: Why China's inclusion in global benchmarks matters

3 Source: Bloomberg, as of 31 January 2019.

Any forecast, projection or target where provided is indicative only and is not guaranteed in any way. HSBC accepts no liability for any failure to meet such forecasts, projections or targets. For illustrative purposes only.

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