By David Roberts, manager of the Nedgroup Global Strategic Bond fund
US dollar bonds have long been the cornerstone of global bond indices, representing nearly 40% of the Bloomberg Global Aggregate index by duration contribution. This dominance is largely due to the substantial issuance by the US government and US-based corporations.
But the inclusion of Chinese yuan-denominated bonds in 2019 marked a pivotal shift in the index’s composition. These bonds now constitute around 10% of the market, positioning them to potentially overtake Japan as the third-largest entity in the near future.
Given that China and Japan together account for a quarter of the global bond market duration, a fund with no exposure to these markets but maintaining a 5-year duration would be considered neutral relative to the rest of the index. This is an important consideration, especially when we see European funds extending their duration up to ten years in Western markets, while asserting they are following the index.
The end of DM bonds proxies for Japan and China?
For the past couple of decades, many investors have safely ignored Japanese bonds (JGBs) due to ultra-low yields and central bank control. The low “beta” of JGBs meant that bond managers could replicate Japan exposure with smaller Western markets when needed.
In contrast, China divides investors. Many remain wary of the protections available to bond holders in times of distress. Recent property market woes have not helped. Even bonds within the index have faced liquidity and transparency challenges.
See also: Hidden gems: Five below-radar funds in the global EM sector
However, with these correlations now shifting, what does it mean for bond investors?
Inflation denial in Japan
Japanese inflation has exceeded the central bank’s target for some time now. To put this into perspective, the latest data shows Japan CPI at 3% compared to headline US CPI of 2.5%. Unusually, Japanese inflation has outpaced US inflation in recent years.
With the US now cutting interest rates, bonds have been rallying. However a US Treasury investor now receives 1.5% per annum above inflation whereas a Japanese bond investor receives 1.5% less inflation. This divergence highlights the changing economic landscape and implications for bond investors.
It is worth noting that the Bank of Japan has kept yields low and inflation high to manage Japan’s huge debt burden, reflecting its lack of independence and role as a direct government agent – something it has been trying to do for more than two decades.
See also: Japan election uncertainty prompts carry trade concerns
Despite the inflation problem and the lack of value for bond investors, the Bank of Japan refrained from raising rates post pandemic, only making minor adjustments to cash rates. Consequently, avoiding Japanese bonds based on pure value and fundamentals, has been a straightforward decision.
Recently, the ruling LDP elected a new leader, Shigeru Ishida, a supporter of hikes. Bond markets rallied before the vote, anticipating no immediate increases. After Ishida’s victory, the Yen strengthened and JGBs fell slightly, hinting at potential future changes. This aligns with our view.
Shelter with not enough value in China
Many investors shy away from China. Information flow is light and liquidity questionable compared with other major markets. For example, Bloomberg quotes a bid/offer spread on ten year Chinese bonds as high as 0.5%. Compare that to Gilts or US Treasuries where there is close to zero bid/offer.
Ignoring all that, many find no value basis for buying Chinese bonds. The Chinese economy has been struggling. The Politburo is targeting a 5% annual growth rate which seems unlikely. Bond markets have rallied to unprecedented levels. The yield on 10-year Chinese bonds recently touched 2%.
But many domestic investors have been so worried about the stock market they sought shelter in bonds. Some bought bonds on a trading basis, expecting the PBOC to slash interest rates as inflation remained barely positive.
See also: Are fixed income funds the panacea, or are they too expensive?
Instead, the authorities unveiled a package of fiscal measures designed to improve the housing market and feed directly into consumer confidence and consumption. The presumption that interest rates would be cut aggressively proved false. And of course, all that stimulus led equity markets higher meaning the chance of making more from the bond than the equity market faded.
Markets saw record one day losses at the end of September for holders of long maturity Chinese bonds. Even 10- yields rose by the most in several years, wiping out several months’ worth of gain.
As domestic buyers turn their attention back to the equity market and international investors remain unconvinced yields have risen enough, the short term outlook for Chinese bonds does not look good.
Irrespective of politics, the lack of value suggests they are best avoided.
Better bond opportunities elsewhere
Buying Japanese or Chinese sovereign debt is hard to justify at current levels. Japan is either embarking on a path of monetary tightening or faces rising yields as the Bank of Japan is deemed further behind the curve. while Chinese yields are at levels never seen before with a wave of fiscal stimulus hitting the economy.
Bond holders should brace themselves for a rocky ride with these assets. For now, we prefer to focus on core bond opportunities elsewhere.
