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China bonds being left behind in clamor for emerging market debt

WITH BOND INVESTORS seen returning to emerging markets en masse next year, the biggest of them all might get the shortest shrift.

Expectations of a China growth rebound as authorities roll back COVID Zero policies are reducing the appeal of its sovereign debt. That’s at a time when funds are loading up on developing nation bonds amid bets that the US Federal Reserve may end its tightening cycle next year.

More attractive opportunities in other markets mean investors are unlikely to reverse the massive China outflows seen in 2022, according to Fidelity International Ltd. and T. Rowe Price Group, Inc. Lingering regulatory and geopolitical risks will also keep capital from returning, said Goldman Sachs Group, Inc. and JPMorgan Chase & Co.

“I doubt that money comes in again,” said Vikas Gupta head of currencies and emerging markets, Asia -acific at JPMorgan said referring to China’s bond market. “If I were to be a positive on growth, I won’t be expecting rates to go down very dramatically,” he said.

Global funds reduced their holdings of Chinese bonds at the fastest pace on record this year as a selloff in Treasuries spurred by Fed hikes pushed US yields above those of China. The yield premium of as much as 253 basis points (bps) offered by benchmark Chinese bonds over US peers in 2020 disappeared to become a discount of around 75 bps as of Tuesday.

While Chinese bonds outperformed global debt markets this year and are on track for positive returns, their performance is beginning to slip. They have fallen the most among Asia-Pacific peers over the last month, finding few buyers as a reopening-led growth rebound is seen boosting returns on domestic stocks and reducing the likelihood of further monetary easing.

“We do not think fixed income flows will return to China in large amounts given the increased regulatory and geopolitical risk environment, as well as the competition from other developed markets,” said Goldman’s Singapore-based strategist Danny Suwanapruti.

Citigroup Inc. forecasts a total return of 3.7% for Chinese government bonds in 2023 on a hedged basis, compared with 5.4% for emerging-market local rates.

T. Rowe Price Group is underweight and has shifted its focus primarily to Latin America on expectations that commodity-exporting countries could benefit from a global tightening cycle and as China reopens. Abrdn is betting on Korean and Indian bonds.

“Over this year, Chinese government bonds have been a fantastic store of value for fixed-income investors and this is a time where we feel like relative to the global opportunity set for bonds — China is looking a little bit expensive,” said Leonard Kwan, a fixed-income portfolio manager at T. Rowe in Hong Kong.

SMALL BUT CRUCIAL
Global funds hold just 2.7% of China’s at 127 trillion yuan ($18.2-trillion) bond market, which is the second-largest in the world. Their holdings have fallen from as much as 3.5% last year. However, their participation as a marginal buyer could matter even more next year if the heavy selloff by retail investors continues.

Still, while bearish bets grow, Morgan Stanley sees China bonds as a good hedge against reopening trades on the risk that an abrupt end to Covid Zero results in a spike in Covid cases that weighs on economic growth in the coming months. Schroder Investment Management Ltd. expects positive outlook for Chinese onshore bonds into 2023, especially if dollar strength reverses.

And Fidelity International, which has turned bullish on some Chinese corporate debt, exposure to government bonds helps provide a hedge against credit risks.

“China’s story had worked for so many years and we still have China government bond exposure,” said Vanessa Chan head of fixed income directing at Fidelity International in Hong Kong. “But we’ll probably be coming down from our allocation.” — Bloomberg

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