In light of the fact that the yuan-denominated bond market is becoming an option for foreigners (with, for example, the Bloomberg Barclays Global Aggregate Index including yuan-denominated bonds as of April 2019), it makes sense to ask yourself if you should or shouldn’t try to grab a piece of such a huge pie, with roughly $13 trillion in outstanding bonds according to BlackRock.
And, indeed, the size argument is one we can consider compelling but it is by no means enough in and of itself to justify a decision. Our attention needs to also shift to the yield dimension and an important observation arises: over the past 14 years, China’s bond yields have for the most part remained in the 3% to 5% area, with only three sub-3% episodes. Bond yields for developed markets, however, have breached the 3% lower bound in 2009 and aside from one very short-lived attempt, have continued drifting lower without looking back, flirting with the 1% zone in 2017 and after a short visit to 2%, are once again in sub-2% territory.
As such, China can be considered a reasonable destination for yield-chasing bond investors. However, as tends to be the case in the investment world, there is no such thing as a free lunch and higher yields tend to be associated with a higher risk factor, which leads us to an entirely new set of variable that need to be included in the equation.
For the most part, these variables revolve around China’s current status on the worldwide landscape. A tricky one, no doubt, in light of the fact that China’s sheer size, population and GDP makes it the #2 economy of the world at this point but variables such as the GDP Per Capital one still place it in “emerging markets” territory.
Why is this important?
Simply because, while bonds tend to be considered the epitome of safety, this is largely because we have been in a bull super-cycle when it comes to bonds for many years. As has frequently been the case throughout history, this tends to numb the critical thinking abilities of investors and lead them to falsely believe that an asset class is safer than it should be considered after a rigorous, rational rather than emotional analysis.
In other words, bonds are a pillar of safety… until they aren’t.
And once the proverbial game of musical chairs ends, things tend to get tricky, as frightened investors go from being euphoric to full-on panic mode. Needless to say, these investors are far more likely to liquidate emerging market bonds than, say, US Treasuries. Therefore, it becomes quite important to understand how the market perceives Chinese bonds at this point and while it’s difficult to accurately articulate how they ARE perceived, it’s quite a bit easier to state how they are NOT perceived and this much is certain: Chinese bonds most definitely do not enjoy the status of “safe haven” assets at this point in time.
Can this change? Yes.
Is it likely to eventually change? Yes.
But for the time being, the fact that Chinese bonds do not enjoy the benefits associated with being considered safe haven assets needs to be included in your analysis. Sometimes, the market tends to do things you consider irrational, which is why it is worthwhile to keep the following adage in mind: the market can remain irrational longer than you can stay solvent.
In other words, no matter how robust and poised to dominate you consider the Chinese economy, the market can decide to panic sell Chinese bonds after a global financial crisis which seemingly has nothing whatsoever to do with China. Why? Simply because during times of panic, investors flock to safe haven assets and Chinese bonds are not considered safe haven assets at this point in time. That can literally be all there is to it.
Perhaps in the future, these market participants will be proven wrong. But even if that is the case, you can lose a lot of money in the meantime by not being positioned properly as an investor and to conclude: yes, Chinese bonds can definitely be considered attractive under the right circumstances but there are significant areas of vulnerability.