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Difficulty: Moderate
This article was written in collaboration with CSOP. While we are financially compensated by them, rest assured that what we have written below is the result of thorough research and presents our independent opinion! As always, we write with our readers’ interest in mind.
1) China Govt Bonds Are Attractive: High Yield, Low Risk
2) Catalyst: Incredibly cheap vs historical
3) Catalyst: Index Inclusion
4) Preferred ETF: ICBC CSOP FTSE Chinese Govt Bond Index ETF
5) For Singapore Investors: How this ETF benefits you
The InvestQuest View:
Onshore China Govt Bonds offer an attractive proposition in our view, given its combination of relatively high yields, investment grade credit rating, relatively low interest rate risk and high stability of the RMB. From a relative valuation perspective, it is also near its cheapest levels relative to Singapore or US Govt Bonds since 2006. As China’s onshore bonds continue to gain inclusion into global bond indices, we also foresee a surge in foreign investor demand over the longer-term.
The ICBC CSOP FTSE Chinese Government Bond Index ETF, the world’s largest pure-play onshore China Govt Bond ETF, provides a cost-efficient way to implement a positive investment view to this sector.
1) China Govt Bonds Are Attractive: Higher Yields with Low Risk
China Govt Bond yields currently stand at 3.18%, significantly higher than the yields of many other government bonds (USA: 0.81%, Singapore: 0.82%, Japan: 0.05%, etc.). This is based on Bloomberg data, compiled 4th November 2020.
But yield should always be evaluated alongside risk. In particular, investors should analyse three types of risk.
- Credit risk: What is the risk of a credit rating downgrade or a debt default by China?
- Interest Rate risk: Do you expect changes in China’s interest rate?
- Foreign Currency risk: Do you expect RMB to appreciate or depreciate?
In the following sections, we’ll see that China currently has a low credit risk, low interest rate risk, and a stable currency.
Low Credit Risk
The higher the credit rating, the lower the credit risk. China currently holds a A+ credit rating by S&P.
In the table below, we show a list of countries that have investment grade credit ratings (i.e. rated BBB- or better by S&P). On the rightmost column, we list the countries’ 10-year government bond yield.
From the above table, we believe that China Govt Bonds are really attractive because:
- It offers a generous yield of 3.18%! Comparing the govt bond yields of the various countries in the table above, we see that China offers the most generous yield (with the exception of India).
- It has a solid credit rating of A+. Many investors may be surprised to know that China has a similar credit rating to Japan, and a higher credit rating than Malaysia and Thailand. It is also comforting to know that China has never before defaulted on its government debt.
India Govt Bonds yield more but are less attractive in our view. While the yield on India’s govt bonds is higher than China’s, we believe that the latter is more attractive, once we factor in inflation.
- As of Sep 2020, India’s inflation rate stood at a much higher 7.34%, compared to China’s 1.7%. This means that India govt bonds are currently offering a negative real yield!
- Furthermore, it’s not really fair to compare India and China, as India’s credit rating is FIVE notches below China’s.
Low Interest Rate Risk
When interest rates rise, bond prices fall. Across several countries worldwide, interest rates are currently very low, but central banks may seek to increase their benchmark rates gradually when their economies gain a more stable footing.
To minimize interest rate risk as an investor, one would want to invest in bonds with both a higher yield (less sensitive to interest rate changes) and a shorter duration (less interest rate risk).
In the table below, we list the yield-to-maturity, duration and credit rating for the FTSE Govt Bond Indices of China, US, Eurozone, UK and Japan.
In the above table, we find China Govt Bonds most appealing because:
- The FTSE China Govt Bond Index has the HIGHEST yield at 3.03% and LOWEST duration of 5.65 years.
- In contrast, the yields of the other govt bond indices are BELOW 0.5%, with significantly HIGHER duration.
How much can interest rates rise before a bond investor starts to lose money? Looking at the table above, by dividing the yield of the bond index by its duration, we can estimate what is the increase in interest rates that will wipe out a year’s worth of yield. Think of this as a computation of a breakeven point!
- For China, this breakeven point is if interest rates rise by 0.54% (3.03% divided by 5.65) or more.
- For US, this breakeven point is if interest rates rise by 0.07% (0.48% divided by 7.18 years) or more.
- For Eurozone, UK and Japan, the breakeven point is close to 0%!
Stable Currency with potential for appreciation
Onshore China Govt Bonds are denominated in RMB, which would expose international investors to RMB currency risk. However, we are not too concerned.
Despite China being a developing country, the RMB is actually a very stable currency. In the chart below, we show the historical volatility for various currency pairs against the US Dollar, in the past 162 weeks. RMB was actually much less volatile than SGD, EUR, AUD, GBP, KRW, JPY, MRY, THB and INR…and the list continues.
Currency stability aside, some might even argue that having some RMB exposure may be beneficial in the longer-term, especially if you are of the view that RMB will appreciate moving forward.
Take this year for example, year-to-date to October, a USD-based investor of the FTSE China Govt Bond Index would have been able to earn a total return of +5.6%, comprised of:
- FTSE China Govt Bond Index Total Return (in RMB terms): +1.7%
- RMB appreciation against USD: +3.9%
While no one can say with certainty where the direction of the RMB is headed, there are several factors supporting RMB’s strength. These factors include but are not exclusive to:
- China’s economy recovering faster relative to other countries, as it has more successfully contained the Covid-19 pandemic.
- China having a persistent trade balance surplus
- China having a much higher interest rate / yield compared to US, making it a more attractive investment option for investors.
- Increasing foreign investor demand for China’s onshore bonds (more details in Section 3)
2) Catalyst: Incredibly cheap vs historical
Bond investors typically track yield differentials over long periods of time. They use this as a reference point for how cheap a government bond is relative to its alternatives.
When comparing to SG and US Bond Yields, the yield differential of China’s Govt Bond Yield is currently very high on a historical basis. In some cases, a wider yield differential would be justified – let’s say if China’s credit rating has dropped relative to its peers.
However, China’s credit rating for long-term local currency debt has actually improved. Since 2004, S&P has upgraded China’s credit rating by three notches from BBB+ to A+.
As such, we see this wide yield differential as a catalyst for a rally in China’s Govt Bond Yields.
Versus Singapore Bond Yield
In the below chart, we plotted the 10-year Govt Bond yields in China (red line) and Singapore (black line), since Nov-2006. Currently, 10-year Govt Bonds yield 3.2% in China and 0.8% in Singapore. As Singapore has a higher credit rating (lower credit risk) than China, Singapore Govt Bonds are expected to yield less.
To assess if China Govt Bonds are truly cheap, we need to look at the yield differential between China and Singapore govt bonds – Now vs What it has been like historically (2nd chart below).
Currently, 10-year China Govt Bonds are yielding 2.4% MORE than 10-year Singapore Govt Bonds (see chart below). This yield differential is near its widest level since 2006! The average yield differential in the past 14-years was 1.4%, and the 14-year peak of 2.6% occurred briefly in 2011. All things equal, this implies that China Govt Bonds are very cheap now, relative to Singapore Govt Bonds.
Versus US Bond Yield
We ran the same analysis by comparing China vs US Govt Bonds and the results are even more compelling.
Currently, 10-year China Govt Bonds are yielding 2.3% MORE than 10-year US Govt Bonds (see chart below). This yield differential is at its widest level since 2006! Note that the average yield differential in the past 14-years was 0.8%. All things equal, this implies that China Govt Bonds are very cheap now, relative to US Govt Bonds.
3) Catalyst: Index Inclusion
Inclusion into major bond indices to bring about US$320b of inflows
China’s onshore bond market has grown to become the second largest globally and index providers are starting to notice. As a result, China’s onshore bonds are now being included into major bond indices, including:
- Bloomberg Barclays Global Aggregate Index (BBGA) since April 2019
- J.P. Morgan’s various bond indices, including the widely followed GBI-EM Global Diversified (GBI-EM), beginning from February 2020
- FTSE World Government Bond Index (WGBI), with inclusion scheduled to start in October 2021.
It is estimated that the inclusion of China bonds into these three indices may bring about US$320 billion of inflows into China’s onshore bond market. Inclusion into the FTSE World Government Bond Index alone is already expected to result in USD150 billion of inflows given the index’s large investor base.
And this is just the start…
According to data compiled by HSBC as of December 2019, foreign ownership of China’s onshore government bonds is still low at under 5% currently. In other emerging market countries, the foreign ownership for local currency govt debt is about 25% on average. For G10 countries, the average figure is even higher at about 40%!
The prospect of increasing foreign investor demand leads us to believe that China’s bond market will be well supported.
4) Preferred ETF: ICBC CSOP FTSE Chinese Govt Bond Index ETF
Most Efficient ETF: ICBC CSOP FTSE Chinese Govt Bond Index ETF
It is not easy for retail or institutional investors to invest directly into onshore China Govt Bonds, as it requires a number of applications to be made and approved by the various regulatory bodies in China.
A more efficient way to access this market would be via the ICBC CSOP FTSE Chinese Government Bond Index ETF. This ETF was recently listed on the Singapore Exchange (SGX) in September 2020, and it is currently the world’s largest pure-play China Government Bond ETF.
We have listed the key investment terms of this ETF in the table below.
The ETF offers exposure to onshore China Govt Bonds in a cost-efficient manner. Despite being only recently listed, it has already attracted a sizable AUM of US$1.1 billion. Its scale enables it to keep the total expense ratio low at 0.25%. Furthermore, trading volume is also sufficiently liquid, which results in a tight bid-ask spread (an indirect transaction cost that many investors often overlook).
While the ETF trades in both SGD and USD, do note that the underlying currency risk is still RMB. The ETF does not hedge currency exposure, which means that the investor will benefit from RMB appreciation and vice versa.
5) For Singapore Investors: How this ETF benefits you
Mix of SG stocks and China Govt Bonds offers better risk reward
In the chart below, we show the historical portfolio return and volatility, assuming varying percentage holdings in two assets – Singapore Stocks and China Govt Bonds. This data is based on the 10-year period between Sep-2010 to Sep-2020. The vertical y-axis indicates the portfolio’s annualized return, while the horizontal x-axis indicates the portfolio’s annualized volatility.
A rational investor would have a preference for a higher return with lower portfolio volatility, which means that portfolios towards the upper left corner of the chart are preferred.
We note that having a mix of Singapore Stocks and China Govt Bonds offered a better risk reward, compared to portfolios solely holding just Singapore Stocks or China Govt Bonds. This is because China Govt Bonds had a negative correlation of -0.4 with Singapore Stocks, offering a significant diversification benefit when holding both assets in a portfolio.
The InvestQuest View:
Onshore China Govt Bonds offer an attractive proposition in our view, given its combination of relatively high yields, investment grade credit rating, relatively low interest rate risk and high stability of the RMB. From a relative valuation perspective, it is also near its cheapest levels relative to Singapore or US Govt Bonds since 2006. As China’s onshore bonds continue to gain inclusion into global bond indices, we also foresee a surge in foreign investor demand over the longer-term.
The ICBC CSOP FTSE Chinese Government Bond Index ETF, the world’s largest pure-play onshore China Govt Bond ETF, provides a cost-efficient way to implement a positive investment view to this sector.
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