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China's Bond Market Rally Falters: Assessing the Impact on Investors

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Michael Chen

March 28, 2024 - 00:31 am

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China's Five-Month Bond Rally Hits a Bump Amid Debt Issuance and Yuan Woes

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Fading Momentum in China's Bond Market

In recent times, the Chinese government bond market has witnessed a phenomenal five-month surge; however, this upward movement is showing signs of fatigue. As the final days of March tick away, indicators currently forecast a break in the trend, driven largely by the anticipation of increased debt issuance in the upcoming quarter coupled with the declining strength of the yuan.

Until now, the impressive traction in China's bond market has propelled the Bloomberg index of Chinese treasury bonds close to a neutral monthly return as March nears its conclusion. The situation is compounded by the fact that the coupon earnings from these bonds, representing the interest income on debt holdings, have sunk to a mere 0.2%—a level not seen in 17 years. Additionally, capital gains have experienced a downturn, which marks the first negative turn in a span of five months.

Rethinking Strategy Amid Changing Economic Conditions

Market specialists are intensifying their focus on the positioning of their bond holdings, after a bullish run fueled by China's tepid economic growth, a monetary policy that leans towards the dovish side, and the impact of substantial liquid capital streaming through the financial system amidst tepid loan demand. It is predicted that additional financial stimuli aimed at rescuing the challenged property sector could prompt investors to pivot toward assets with higher associated risks. Moreover, the Chinese government is planning to issue more government bonds, an action that is expected to drive yields upward.

Renewed apprehensions regarding the underperformance of the yuan have likewise sparked conversations about whether the People's Bank of China (PBoC) might postpone expected cuts in interest rates as a measure to stabilize the country's currency.

Zhaopeng Xing, a seasoned strategist at Australia & New Zealand Banking Group, articulates his perspective stating, "The likelihood of a rate cut in the ensuing quarter seems slim, in our opinion, and the surplus of liquidity could return to normal levels as government bond issuance intensifies. This scenario would likely exert upward pressure on bond yields."

The Dilemma of Low Yields and Narrowing Gaps

In the event that the potential for a supply shock proves to be moderate in its effects, the allure of bond returns may have already diminished. The frenzied pursuit of fixed income assets has suppressed benchmark sovereign yields to their lowest in two decades. Concurrently, the additional gain investors glean from longer-maturity or higher-quality corporate bonds is dwindling.

The future of bond yields presents a challenging landscape as stated by Yang Hao, a fixed income analyst at Nanjing Securities, "The margin for returns does not seem promising. With both term spreads and credit spreads being extremely tight, there's virtually no extra yield to be gained. Coupon rates are already low, and capital gains become uncertain without the presence of new buyers willing to purchase bonds at lower yields."

A Market Divided: Bulls and Bears Debate

Opinions amongst investors are polarized, according to Larry Hu, the head of China Economics at Macquarie Securities Ltd. In a recent analysis, he depicts the dichotomy of market sentiment. "Bears surmise that the market may have overextended, while the bulls highlight the lack of credit demand within the real economy," Hu comments. He suggests that this shortfall in credit could trap liquidity within the interbank market, thereby fueling further demand for bonds. It is noteworthy that banks, flush with surplus capital that they are unable to lend out, are often inclined towards purchasing bonds to generate returns.

Analyzing the Dynamics of Aggressive Pricing

An element that merits attention is the current pricing mechanism within the market. The rate on ten-year government bonds hover around 2.3%, approximately 20 basis points beneath the rates of one-year policy loans. Some market participants view this discrepancy as evidence that traders may have been overly assertive in expecting additional rate cuts from the PBoC.

This pricing dynamic hints that bonds with longer maturities might be more susceptible to market corrections when compared to their shorter-term counterparts, especially if there is an uplift in economic fundamentals. Pondering this, Yongbin Xu, director of rate strategy at U-shine Investment Group, reflects, "An improving economy could potentially cause the yield curve to steepen, with long-end yields moving upwards, thus introducing significant uncertainty. Finding a sound investment position remains elusive."

The Outlook for Bond Supply and Demand

Compounding the situation, the Chinese Finance Ministry has laid out plans for the issuance of a one trillion yuan ($138 billion) ultra-long special government security within this year, with market traders eyeing the upcoming second quarter as a potential time frame. This move is set to rectify the shortfall observed in bond issuance during the first quarter.

Despite the looming increase in bond supply, firms such as JPMorgan Asset Management manifest a robust belief in the market's capacity to assimilate the excess debt and maintain a constructive stance towards Chinese bonds. This sentiment was echoed by Jason Pang, Asia FX & rates portfolio manager at JPMorgan, during an interview with Bloomberg Television last week, where he hinted, "The rally might be approaching its final stretches."

Final remarks on China’s bond market, courtesy of Bloomberg L.P., can be viewed through the following article. As we monitor the interplay between the PBoC's policies, the evolving economic landscape and market responses, the trajectory of China's bonds in the near future is a narrative of high interest to investors and analysts alike.


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