Taking stock of the Chinese bond market


A version of this article was previously published in the October 2021 issue of Morningstar ETF Investor. Click here to download a free copy.

The Chinese economy is a juggernaut; its bond market is a booming superpower. At the end of 2020, the Chinese bond market was the second in the world. The total value of Chinese bonds was nearly $ 19 trillion, or 15% of the global bond market.

Today, Chinese bond yields are significantly higher than those of the United States, the United Kingdom and the Eurozone. And Chinese bond prices are not strongly correlated with US Treasuries or the US stock market. At first glance, this would seem to make it a good diversifier in a US-centric portfolio. But a Chinese bond allowance is not a free meal. Despite its size, this market is still in its infancy and investors need to consider many complications and nuances. Additionally, only a few exchange-traded funds currently offer exclusive exposure to the Chinese bond market, and the many ETFs that hold large allocations to China in their portfolios have disparate goals and exposures.

Nonetheless, exposure to the Chinese bond market has the potential to supplement a core position. Here I give an overview of the Chinese bond market and rate the ETF options that provide exposure there.

The Chinese bond market

The Chinese bond market consists of three sub-markets, defined by the place of issue of the bonds and their currency.

The most important is the Chinese onshore bond market in local currency. These are bonds issued in mainland China and denominated in renminbi. With a total of $ 17.5 trillion, it is by far the largest of the three submarkets. Most of the bonds of the Chinese government and strategic banks are issued in mainland China in renminbi. The relatively high yields of these bonds and the low credit risk make this the most attractive submarket.

The second largest submarket is the Chinese onshore hard currency bond market. These are bonds issued by China or Chinese entities in mainland China in developed market currencies, usually in US dollars. Corporate bonds represent the biggest slice of this pie.

The third sub-market is the Chinese offshore bond market in local currency. These are bonds issued outside of mainland China (mainly Hong Kong) and denominated in renminbi.

Within these three submarkets, there are generally three categories of issuers: governments, strategic banks and corporates.

Government bonds include treasury bonds issued by the Chinese Ministry of Finance and bonds issued by local government entities (similar to municipal bonds in the United States). According to Bloomberg data, local government bonds were the largest class of issuers in China, accounting for nearly 23% of the total onshore local currency market, in the first quarter of 2021. The local government debt market was tiny before 2015 and has multiplied since. , because the Chinese government has authorized local government finance vehicles to swap their debt for state and municipal bonds in order to improve local governments’ credit profiles and reduce their borrowing costs. The Chinese Treasury bond market is actually smaller than the local government bond market, accounting for just 18% of the onshore local currency market in 2021.

Bonds of strategic banks are sometimes classified under the umbrella of government bonds, but they have been separated from government bonds by the major index providers. The State Council of China has established three strategic banks to promote economic growth: the Development Bank of China, the Import-Export Bank of China, and the Agricultural Development Bank of China. These bonds are considered risk-free assets because they are explicitly backed by the Chinese government. But political bank bonds generally offer slightly higher yields than Chinese Treasury bonds because their tax treatment is less favorable for Chinese investors. The size of the bank bond market is roughly the same as the Chinese Treasury bond market, but bank bonds are more liquid.

The Chinese corporate bond market is diverse and fragmented. It is dominated by state-owned enterprises, as companies without explicit government support were largely prohibited from issuing bonds until 2007. State-owned enterprises still represent the bulk of the market today. About 97% of Chinese corporate bonds in local currency are rated AA or higher; this can make it difficult to assess Chinese companies’ credit risk from their credit ratings, as the local scale on which they are rated lacks significant depth. Although many Chinese companies have received ratings below investment grade, these are exclusively hard currency bonds.

Historically, foreign investors’ access to the Chinese bond market has been limited to hard currency and local offshore currency markets. Two recent events have opened up the local currency market, allowing international participation in the Chinese Treasury and strategic banking markets. The creation of Bond Connect in 2017 simplified market access for non-Chinese investors, while the inclusion of Chinese local currency government bonds in major bond indices invited greater participation. In October 2021, three major bond index providers included (or announced that they will include) Chinese Treasury bonds: Bloomberg (in April 2019), JPMorgan (in February 2020) and FTSE Russell (in October 2021). Bonds of strategic banks are only included in Bloomberg indices.

ETF offering exposure to the Chinese bond market

In October 2021, two ETFs offered pure exposure to the onshore local currency market: Krane Shares China Credit Index ETF (KBND) and the VanEck China AMC China Bond ETF (CBON). ETFs manage exposure to Treasury bonds, strategic bank bonds and corporate bonds so that the sector weighting at each rebalance is 25%, 25% and 50% for KBND and 20% respectively, 30% and 50%. respectively, for CBON. CBON was launched in November 2014, while KBND started tracking its current index in June 2021.

Although pure-play options are limited, several ETFs have large allocations to Chinese bonds; as of October 2021, 13 ETFs had allocations of at least 5%. But as Exhibit 1 shows, they are a motley team.

The choice between pure-play and non-pure-play is the main criterion for exposure to the Chinese bond market. Each choice has advantages and disadvantages. To assess them, you need to understand the risks associated with each option.

Understand the risks

Chinese bonds offer higher yields than similar bonds from developed market issuers, but the extra yield is compensation for the risk. Notably, the Chinese bond market is much less liquid than the US investment grade bond market, so information is priced slower and less reliably. For example, the International Monetary Fund noted that in 2017, Chinese banks held 70% of all Chinese Treasury bonds and tended to hold them until maturity. Gathering useful market information is also difficult for corporate bonds given the lack of granularity that characterizes the onshore market’s credit rating scale, as almost all Chinese corporate bonds are rated AAA or AA. Chinese rating agencies.

Pure play exposure to the Chinese bond market is a risky proposition. In addition to the risks inherent in Chinese debt, the two funds currently offering pure play exposure hold compact and highly concentrated portfolios. Therefore, the poor performance of an issuing company could have a significant impact on performance.

The non-pure-play exposure to Chinese debt comes with an assortment of risks. For example, emerging market local currency bond funds tend to offer exposure to at least a dozen other currencies, and the issuers represented often lack attributes that make Chinese debt attractive (such as growth and stability). . Emerging market hard currency diversified bond funds are highly exposed to credit risk by limiting their mandate to corporate bonds or lower quality bonds.

An ETF offering exposure to the premium non-USD global bond market is the more conservative option for non-pure-play exposure. These ETFs lean heavily towards China, offering attractive returns without incurring a lot of credit risk. But hedging currency risk also reduces the potential for diversification from a US investor’s perspective.

Put it all together

Despite the risks, exposure to Chinese local currency debt can add value to a bond portfolio. Table 2 illustrates the performance of three bond portfolios over five years through September 2021. The three portfolios represent a core bond portfolio with no exposure to Chinese debt (iShares Core US Aggregate Bond ETF (AGG)), a core bond portfolio with exposure to non-pure Chinese debt via a premium non-USD global bond ETF (60% AGG and 40% iShares Core International Aggregate Bond ETF (IAGG)), and a core bond portfolio with exposure to Chinese debt via a pure-play ETF (80% AGG and 20% CBON). Holding Chinese debt-free core bonds provided the least attractive risk-adjusted performance.

Of course, the past is not a prologue and there is no guarantee that the next five years will produce the same result. Interest rates have been volatile in the United States for the past five years, which detracted from AGG’s performance given its tilt towards US Treasuries. And IAGG did not hold any Chinese debt until April 2019, so its performance will likely be more volatile in the future. But the diversification and additional return provided by Chinese local currency bonds is expected to continue as its bond market continues to mature and international participation continues to increase.

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