Overview
Sluggish growth and geopolitical risks continue to fuel debates on the merits of investing in China. But beyond those arguments, one asset class stands out as a beneficiary of weak macro conditions: top-rated Chinese onshore bonds.
Why high-grade onshore bonds look attractive
China government bonds (CGBs), along with other high-grade, government-related debt in the country’s onshore market, stand to benefit from an economic slowdown, monetary easing, and weak inflation that teeters on the brink of price declines. Chinese policymakers are battling a property downturn to stabilise the economy, having already completed several rounds of interest rate cuts and liquidity injections for the country’s banks since 2022.
Although aggressive further easing looks unlikely, we expect loose monetary conditions to continue in the near term. Consumer price inflation has been fluctuating near zero for months. Against this backdrop, top-rated Chinese onshore bonds are likely to outperform most risk assets in the country, as their stable cashflows become more attractive amid feeble inflation and growth. Appropriate currency hedging could further structurally enhance their performance.
How to get exposure to China’s onshore bonds
About one third of the Bloomberg China Aggregate Index, known as the China Agg, is made up of CGBs, while the rest consists mainly of government-related securities such as agency bonds and local-authority debt, plus a small portion of corporates.
The China Agg has outperformed major government bond indices globally over the last decade. On top of this solid performance, analysis by Fidelity International shows that a sizeable excess return was achievable for US dollar-based investors over the same period through well-timed currency hedges by hedging the renminbi against the greenback under certain pre-determined conditions. Most global funds need protection against renminbi volatility when investing in the index, but deciding when and when not to hedge can have a big impact on returns.
A simple hedging rule to boost returns
When interest rates are meaningfully higher in China than in the US, our analysis shows it is generally wiser to leave the China Agg unhedged. This is because the renminbi tends to outperform the dollar when Chinese rates are comfortably above the US, for example when the 3-month forward CNH (offshore renminbi) interest rate is more than 200 basis points above the 3-month forward USD interest rate. However, when US interest rates are higher, or at least not meaningfully lower, it usually becomes more profitable to hedge renminbi volatility.
A dollar-based investor could therefore seek to improve returns from a Chinese onshore bonds portfolio by hedging the renminbi whenever the 3-month forward USD interest rate is higher or less than 200 basis points lower than the CNH rate, implying downward pressure for the renminbi. Fidelity’s analysis reveals that hedging an investment in the China Agg index this way would have delivered a 78 per cent gain in dollar terms over the 10 years through to the end of 2023. By comparison, the return would be 54 per cent in the event of hedging throughout the 10-year period, and only 40 per cent with no hedging at all.
In addition, such an investment would have exhibited a moderate annualised volatility of 2.9 per cent - compared with 2.2 per cent in the always-hedged scenario and 4 per cent with zero hedge - and a Sharpe ratio of 2.1, which is a higher risk-adjusted return than those in the always-hedged and never-hedged scenarios.
Generating alpha is practical
Our analysis is intended to show that generating stable alpha on high-quality Chinese onshore bonds is feasible and not especially complicated, although past performance is no guarantee of future results.
China accounts for more than 9 per cent of the popular Bloomberg Global Aggregate Index (Global Agg), which is tracked by some USD $2.5tn of funds and portfolios. The data shows that actively managing exposure to Chinese onshore bonds has the potential to generate significant annual alpha (20 basis points by our calculations) relative to this global index, reducing portfolio volatility and increasing Sharpe ratios.
Moreover, the China Agg offers diversification benefits, due to its ultralow correlations with leading global assets. For instance, the correlation between the index and US investment-grade bonds over the last 10 years was near zero.
These low correlations can be partially attributed to the modest level of foreign ownership in China onshore bonds, which is currently less than 3 per cent. Investing in China’s onshore bond market is clearly a minority sport. But that’s precisely why it is worth considering, especially given the economic headwinds.
