A closer look at the growing appeal of China bonds for global investors

Key takeaways

• Elimination of old barriers to investment and increasing inclusion in global indexes suggest a building tailwind for China bonds.
• Low historical volatility and high relative yields give the asset class a unique appeal in today’s fixed-income environment.
• As a complement to either global government bonds or EMD, China bonds have historically dampened volatility while preserving or enhancing returns.

At over US$15 trillion,¹ China’s bond market is now the second largest in the world, behind only the United States, and has been among the fastest-growing bond markets globally, expanding at an annual rate of more than 12% over the past five years. Yet despite the increasing size and importance of the market—China being the second-largest economy in the world as well as the second-largest global trading economy—many investors, particularly overseas investors, still have relatively limited exposure to China bonds in their portfolios. This piece examines the merits of adding China bonds to a diversified fixed-income portfolio and, in particular, the diversification benefits such a position can offer relative to a broad-based emerging-market debt (EMD) allocation.

China bonds are more accessible to overseas investors than ever before

For international investors, owning China bonds outright wasn’t always easy. But significant progress has been made over the past five years in opening up China’s financials sector to international investors, and with it has come greater interest in the China bond market. With the removal of QFII/RQFII quotas that were previously required to access the onshore China bond market and the introduction of the China Interbank Bond Market and Bond Connect channels in 2016 and 2017, respectively, China has made it much easier for overseas investors to directly access the onshore market. Bond Connect, in particular, has stood out as a preferred channel for overseas investors due to its relatively fast application procedure and facilitation of electronic trading through familiar offshore trading platforms.

These changes in policy have in turn influenced the composition of various global bond indexes, which has further served to drive global investors into the onshore China bond markets. The Bloomberg Barclays Global Aggregate Bond Index and the J.P. Morgan GBI-EM Global Diversified Index began to phase in onshore China bonds in 2019 and 2020, respectively, and it’s recently been announced that China bonds will be added to the FTSE World Government Bond Index (WGBI) progressively beginning in October 2021,² with a target weight of 5.25%. The WGBI inclusion confirmed that the addition of China bonds will be phased in over a 36-month period; with up to US$1.5 trillion in assets tracking the WGBI, this implies monthly inflows of around US$2 billion into China bonds and as much as US$79 billion in total inflows during the phase-in period.³

It’s no surprise that increased inclusion of China bonds in indexes has naturally had a trickle-down effect, nudging more global investors into the market, and we’ve started to see those effects already play out. In 2020, foreign inflows to China bonds reached a record of CNY1.06 trillion and total foreign ownership of onshore bonds reached CNY3.3 trillion by the end of 2020, with foreign ownership of China government bonds (CGBs), specifically, crossing the 10% mark by the end of February 2021.⁴ The pace of inflows to China bonds is expected to continue to increase over the next several years, partially driven by the expanding index inclusion, but also because the new attention has led investors to take notice of the attractive fundamentals the asset class offers.

It’s no surprise that increased inclusion of China bonds in indexes has naturally had a trickle-down effect, nudging more global investors into the market.

A rare combination of high-quality and high relative yields

In an environment of low and even negative interest rates in many developed markets, the yields for China bonds stand out at 3.07%⁵ for 10-year CGBs, offering more than twice the yield of 10-year U.S. Treasuries. Accounting for inflation, the real interest rate for China bonds is also among the highest of any international government debt rated A or higher, currently around 1.8%.⁵

China’s yield advantage is in part tied to its unique policy stance looking ahead over the medium term: China’s central bank, the People’s Bank of China (PBoC), is currently striving to balance promoting the continued recovery of the domestic economy while also implementing fiscal consolidation and normalizing credit growth to avoid overheating the economy. Compare this with most other developed markets in which interest rates remain near zero. The PBoC has signaled that it will continue to pursue a prudent monetary policy while providing liquidity support to targeted sectors within the economy where needed, and it appears unlikely to tighten monetary policy for the foreseeable future.

China bonds’ higher historical returns haven’t entailed excessive volatility

In addition to the incremental income, another key reason for investors to consider adding China bonds to their portfolios is their diversification and risk mitigation benefits. Looking at the period from January 1, 2013, to May 31, 2021, unhedged China bonds offered more than twice the return of global government bonds, with about 92% of the volatility. Meanwhile, compared with EMD, China bonds offered roughly 87% of the returns, but with less than half the risk over the same time period.⁶

China bonds have offered attractive risk-adjusted returns

Annualized returns vs. volatility for China bonds, global government bonds, and EMD (January 2013–May 2021)

Source: Bloomberg, as of May 31, 2021. China bonds are represented by the Markit iBoxx ALBI China Onshore Total Return Index (TRI), global government bonds are represented by the FTSE World Government (Gov) Bond Index, and emerging-market debt is represented by the J.P. Morgan EMBI Global Diversified Composite Index. See endnotes for index definitions. 

Capturing higher yields hasn’t required accepting heightened volatility

U.S. Treasuries have long been viewed as a safe haven asset, but China bonds may be worth considering as an effective port for investors to ride out the occasional storms of market volatility. In the first quarter of 2020, when a wide range of assets sold off as the scope of the COVID-19 pandemic was coming into focus, China bonds returned 1.8% versus 2.0% for global government bonds and
–13.4% for EMD over the same period, in U.S. dollar terms. Similarly, during the fixed-income sell-off in the first quarter of 2021, when U.S. rates rallied aggressively, China bonds provided investors with more stable returns: China bonds returned 0.28% in U.S. dollar terms versus –5.68% for global government bonds and –4.54% for EMD over the same period. Further, if we look at the maximum drawdown experienced over longer time periods, China bonds once again had a lower drawdown than both global government bonds and EMD.⁶

China bonds have offered attractive downside protection

Maximum drawdown for China bonds, global government bonds, and EMD
(January 2013–May 2021)

Source: Bloomberg, as of May 31, 2021. China bonds are represented by the Markit iBoxx ALBI China Onshore Total Return Index (TRI), global government bonds are represented by the FTSE World Government (Gov) Bond Index, and emerging-market debt is represented by the J.P. Morgan EMBI Global Diversified Composite Index. See endnotes for index definitions. 

It’s important to acknowledge that part of China bonds’ low historical volatility was due to China’s domestic market being generally closed off from global investors and thereby insulated from the occasional bouts of global market volatility. But even while China’s onshore bond market continues to open up, with increasing participation from overseas investors, we fully expect the China bond market will continue to benefit from significant domestic demand for the foreseeable future, with onshore investors and banks dominating the local market. For that reason, we believe the correlation of China bonds with global markets will likely remain comparatively low—particularly given the relative independence of China’s economy and policy cycles—with relatively little influence felt from the U.S. Federal Reserve.

The fundamentals of China’s economy stand out on the global stage

Following this year’s National People’s Congress, China announced its key economic targets for 2021 to support its economic recovery; China officials have worked to implement a pro-growth policy stance for 2021 and have set a growth target above 6% for the year. Consensus economic forecasts, meanwhile, expect China to grow at 8.5% for the year.⁷ While the government looks likely to work to rein in excessive financial leverage and to mitigate against financial risks, we still expect monetary policy to remain relatively stable this year, with the PBoC unlikely to tighten policy rates in favor of continued targeted liquidity. The outlook for inflation also looks to remain relatively benign, and we expect it should stay within the government’s 3% official target; food prices, for one example, have declined from their elevated levels from a year ago. We don’t anticipate any catalysts for significant swings in either nominal or real yields, and from a valuation perspective, we believe China bonds look attractive at current levels given the supportive economic backdrop.

The PBoC is keen to avoid injecting excessive liquidity into the market, creating conditions that are too loose, leading to financial instability. As a result, there’s been some uptick in defaults, including in the state-owned enterprise (SOE) sector; the default rate within the SOE sector remains low, however, at less than 1% for 2020.⁸ While credit differentiation is expected to increase over time—and there could be less government support for weaker SOE names or for those that have less strategic importance—the overall picture for credit is expected to be relatively stable over the near term.

Of course, currency appreciation has been another tailwind for unhedged offshore investors, and the trend has been working decidedly in their favor. In 2020, the renminbi gained 6.7% against the U.S. dollar on the back of general dollar weakness, strong demand for China assets, and the outperformance of China’s economy in the second half of the year, driven by strong global demand for China’s exports. So far in 2021, we’ve seen more of the same, with the renminbi strengthening 2.5% against the U.S. dollar through the end of May. Similarly, the renminbi has appreciated 2.4% and 4.0% against the euro and the Swiss franc, respectively, over the same period. In the near term, the PBoC may be keen to restrict the pace of further appreciation of its currency as the economy is still in the early stages of its postpandemic recovery. Over the medium term, however, the renminbi is expected to continue to be supported by higher flows into onshore China equities and fixed-income assets, which represents a meaningful potential driver of returns for offshore investors.

Scenario case study: how China bonds can fit into a diversified portfolio

Naturally, making the space to fund an allocation to China bonds inevitably requires investors to dial down exposure to another allocation within their portfolios. We’ll examine two scenarios: funding a China bond position as a supplement to either global government bonds or to an EMD holding.

As always, the proportion of the investment is subject to individual client needs and goals. But to take one hypothetical example, by replacing half a portfolio’s allocation to the WGBI with CGB, the portfolio risk would have declined by nearly 25% on a historical basis, while the total return would have almost doubled. This is what we’d expect given the relatively low historical volatility in China bonds and paltry yields on offer from most developed-market government debt.

Combining China bonds with global government bonds can enhance returns and reduce overall risk

Annual risk/return profile for a hypothetical portfolio (January 2013–May 2021)

On the other hand, replacing part of an EMD allocation to China bonds primarily works as a risk-reduction trade. For example, a portfolio of 50% EMBI and 50% CGB would have reduced the portfolio risk by more than one-third while sacrificing only marginal returns: The 50/50 mix would have generated roughly 95% of the returns of an all-EMD allocation.

For portfolios that currently invest in global government bonds or global EM bonds, it’s worth considering investing in China onshore bonds, which have historically helped to both reduce volatility and enhance returns.

Adding China bonds to an EMD allocation can reduce volatility without a significant sacrifice of returns

Annual risk/return profile for a hypothetical portfolio (January 2013–May 2021)

Source: Bloomberg, as of May 31, 2021. China bonds are represented by the Markit iBoxx ALBI China Onshore Total Return Index (TRI); emerging-market debt is represented by the J.P. Morgan EMBI Global Diversified Composite Index. See endnotes for index definitions. 

A compelling allocation for a range of portfolios

We believe the case to strategically add China bonds to portfolios is a strong one for global investors, whether they’re seeking to take advantage of the higher yields on offer in a generally low-yielding world or looking for an asset class with limited volatility and low correlation. The time has arguably never been better, with flows into the asset class projected to increase significantly over the next three years and investor-friendly policies and reforms making access easier than ever for offshore investors. We expect the growing interest in China onshore assets to be a multi-year theme as global investors recalibrate their portfolios to reflect the structural changes to the global economy over the past decade while also seeking to benefit from the growing dynamism in China’s economy over the next decade and beyond.

The Markit iBoxx ALBI China Onshore Total Return Index (TRI) tracks the performance of bonds issued by the Chinese Ministry of Finance and select Chinese policy banks. The FTSE World Government (Gov’t) Bond Index tracks the performance of fixed-rate, local currency, investment-grade sovereign bonds. The J.P. Morgan EMBI Global Diversified Composite Index tracks the performance of U.S. dollar-denominated Brady bonds, Eurobonds, and traded loans issued by sovereign and quasisovereign entities. The index caps its exposure to countries with larger amounts of outstanding debt. It is not possible to invest directly in an index.

1 Bank of International Settlements (BIS), Manulife Investment Management, as of June 2020. 2 On March 29, 2021, FTSE Russell confirmed that China government bonds will be added to its widely followed World Government Bond Index (WGBI) with a weight of 5.25%. FTSE Russell, as of March 30, 2021. 3 Goldman Sachs, as of March 31, 2021. 4 Standard Chartered Bank, as of March 2021. 5 Bloomberg, as of May 31, 2021. 6. Bloomberg, as of May 31, 2021. China bonds are represented by the Markit iBoxx ALBI China Onshore Total Return Index (TRI), Global Government Bonds are represented by the FTSE World Government (Gov’t) Bond Index, and Global Emerging Market bonds are represented by the J.P. Morgan EMBI Global Diversified Composite Index. 7 Bloomberg, as of March 31, 2021. 8 Goldman Sachs, as of March 24, 2021.