Why China is the future of the bond market
Fixed Income Strategist
Although the past few weeks have seen the 10-year Treasury yield hold stable around 2.9%, US Treasury yields have risen by approximately 45 basis points since the beginning of the year.
One would expect that an upward movement in Treasury yields would cause volatility in the fixed income space, provoking the yield of USD-denominated debt worldwide to rise faster than Treasuries. To the the surprise of many, however, this has not been the case – the option-adjusted spread of USD bonds has actually changed little since January 1.
While the OAS of investment grade USD dollar bonds has held stable since the beginning of the year, high yield bond spreads have actually fallen, making these credits even less attractive than they were at the end of last year. This is surprising given that the volatility index spiked above 30% at the beginning of February, provoking a selloff in the equity market, and one would expect investors to have sold the riskier assets in their portfolio, including junk bonds.
This is a clear sign that while Treasury yields may raise, and volatility spike, the demand for USD credit remains very high and as soon as there are signs of weakness, investors buy the dip. To make things even more difficult, investors are increasingly buying to hold to maturity for the simple reason that if spreads are going to tighten, it is difficult to find a replacement once a bond is sold.
Alternatively, of course, if spreads are going to widen, it is therefore more convenient to lock in the yield to maturity and stay short maturities.
Turning to emerging markets, things are no different. While the USD aggregate yield for USD credits has risen to 4.95% from 4.53% on January 2, the OAS is trading only one bps wider compared to the beginning of the year despite fluctuations.
Some regions suffered more than others, however, with China being one of them.
Investors have kept their distance from Chinese bonds for various reasons. Last year, they did so because they were afraid of a North Korean war; now, with the North Korean problem on an apparent path towards resolution, it’s the Trump administration's chance to target China with revenge plans in order to make up for its trade deficit.
We must not forget that investors don’t yet trust the Chinese bond market. It is widely believed, after all, that Chinese business practices remain blurry, and the oft-employed guarantees of the Chinese government do not provide the same security that might accompany a guarantee from other EM countries. Also, Chinese policy-making, including central bank decisions, is dominated by the Communist Party.
The market's faith in the Chinese financial industry is being weighed and the headlines point to a merger of the China Banking Regulatory Commission and the China Insurance Regulatory Commission, with some of their current powers – such as financial regulations and prudential oversight – passed on to the People’s Bank of China.
The market is also anxiously waiting for the successor of current PBoC chair Zhou Xiaochuan, who is set to retire after holding office for 15 years.
These changes are not taken lightly by bond investors. In fact, many are already noting that the PBoC is becoming more and more important within international markets. Whenever monetary policies are changed, various industries are shaken as many companies are heavily exposed to the Chinese market.
Although all of these factors are aligned against Chinese bonds, investors may be undervaluing the potential that lies within this market, particularly now that the country is opening up to foreign investors.
Bond Connect is a new mutual market access scheme designed to give international investors access to the local Chinese market without having to set up an onshore account. This is something that will revolutionise the Chinese bond market as international investors presently only participate in a very small percentage of the Chinese bond market.
There are plenty of reasons for international investors to want improved access to Chinese bonds. First of all, its yields are higher than in other emerging markets. Secondly, there is a huge potential for tightening now that international flows are preparing to enter the market.
To provide an example, the yield of the two-year Chinese government bond in yuan is around 3.35%. By way of comparison, the yield on two-year Treasuries is approximately one point lower, around 2.25%. Because the Chinese yield curve is extremely flat, investors wouldn’t even need to invest in longer maturities in order to obtain higher yields, meaning that they can remain comfortabe in shorter and less risky maturities.
Another factor that may lure foreigner investors is the possibility of investing in yuan-denominated fixed income securitie. The currency is strengthening against the US dollar, and has posted a 3.1% rise since the beginning of the year and 10% since January 2017.
Although many regard the Chinese market with suspicion, all signs point toward China being hard to ignore in future.
This will happen sooner rather than later, and Saxo Bank wants to give investors the opportunity to trade in all types of securities. As such, we are working towards implementing Bond Connect within our trading platform. This means that the Saxo investor will soon be able to access a market that was a mere dream just a few short years ago.