- Compared to developed-market sovereign debt, Chinese government bonds offer global investors higher yields and possible portfolio diversification.
- Our model-driven analysis finds that, in a hypothetical portfolio of developed-market government bonds, a 10%-portfolio-weight reallocation to local-currency Chinese government bonds decreased risk by 7%.
- Investors may also weigh practical considerations such as higher potential domestic Chinese inflation, foreign-exchange fluctuations and liquidity risk.
Global investors’ interest in Chinese government bonds has risen — perhaps in part due to the addition of China to existing bond-market indexes.1 Local-currency (CNY) Chinese government bonds also offer relatively high yields and potentially large investment capacity, given the sector’s significant size. Asset allocators may be thinking about adding Chinese bonds to their portfolios. What could be the potential impact on portfolio risk, according to our model, and what other risks might investors consider?
The Chinese Sovereign-Debt Market Is Large
October’s bond issuance in U.S. dollars of USD 6 billion by the Chinese government caught the headlines, but it is important to put this sector in perspective.2 China is the 10th-largest market (at about USD 18 billion) in terms of the outstanding amount of USD-denominated sovereign bonds. However, with the equivalent size of USD 2.8 trillion, the CNY-denominated Chinese government-bond sector is a much larger market.3 In fact, among individual countries, China is the third-largest sovereign-debt market in the world, behind only the U.S. and Japan, as shown in the exhibit below.
China’s Sovereign-Bond Market Among the Largest in the World
Higher Yields May Increase the Appeal to Global Investors
Yields on 10-year Chinese government bonds issued in USD are trading about 50 basis points (bps) higher than yields on U.S. Treasurys, but lower than yields on AA-rated U.S. corporate bonds, suggesting that the market considers China’s creditworthiness relatively strong.4
Local-Currency Chinese Bonds Currently Offer Higher Yields than Treasurys
Over the past eight years, local-currency Chinese government bonds have traded at significantly higher yields than those of U.S. Treasurys. This divergence has increased during 2020, as the Federal Reserve bought a record amount of Treasurys as it sought to calm financial markets and stabilize the economy in response to the COVID-19 pandemic. As of Nov. 10, yields of China’s CNY-denominated 10-year bonds were 250 bps above those of comparable Treasurys.
Chinese Bonds Could Diversify Portfolio Risk
Institutional investors may wish to consider the potential diversification provided by adding Chinese government bonds to an existing portfolio. To further investigate, we consider a hypothetical asset manager with a benchmark consisting of developed-market government bonds.5
We constructed five hypothetical portfolios, where each portfolio maintained an overweight to one specific country or region.6 We then applied the MSCI Multi-Asset Class Factor Model to assess portfolio risk. The model provides a forecast of the annualized return volatility of a global bond portfolio using USD as the base currency, taking into account yield and currency volatilities and their correlations.
Based on the model, the projected annualized total risk (as measured by return volatility) of a portfolio tracking the benchmark is 5.4%. Adding a 10% overweight to China in the portfolio would have reduced portfolio risk to 5.0%, resulting in a 7% reduction in total risk.7 Alternatively, the portfolio’s total risk would have been 5.3% for an overweight to the U.S. and 5.5% for an overweight to the eurozone.8
We invite you to use the interactive exhibit below to assess the impact on the total risk and total active risk of overweighting a specific sovereign-bond sector by different amounts.
Impact on Risk from Overweighting: An Interactive Portfolio-Level Look
Based on Nov. 10, 2020, market data.
Foreign-Exchange and Inflation Risk
Global investors considering local-currency Chinese bonds may also consider risks from foreign-exchange fluctuations and domestic Chinese inflation. The realized volatility of the USD/CNY exchange rate has generally been much lower than volatilities of other major currencies compared with the USD, as the exhibit below shows — suggesting that Chinese government bonds may contribute diminished foreign-exchange risk to USD-based investors than other local-currency sovereign bonds.
Attractive inflation-adjusted returns are one of bond investors’ primary goals. Reported Chinese inflation over the past year has been much more volatile than U.S. inflation.9 The current large difference in yields between Chinese government bonds and Treasurys may overstate after-inflation returns if China’s future inflation exceeds that in the U.S.
Exchange-Rate Volatility vs. USD Has Been Low, but Chinese Inflation Has Been Volatile
Less Liquid, but Future May Bring Changes
With an approximate bid-ask price spread of 20 bps in the 10-year sector, as of Nov. 10, CNY-denominated Chinese government bonds are not as liquid as sovereign bonds from the U.S., Japan, U.K. or Germany, which have bid-ask spreads of about 4 to 5 bps, as calculated by the MSCI Bond Liquidity Model. Fundamentally, however, the large size of the sector may potentially improve liquidity, if global participation in the sector grows and investors find they may be able to trade in larger sizes.
Is the Search for Yield Worth the Risk?
Low yields in developed-market sovereign bonds are pushing investors to consider new sectors of the bond market. With its relatively high yields and potential for portfolio diversification, the local-currency Chinese government-bond market is generating increased interest from global investors. But investors might consider risks to the sector, including potential inflation and exchange-rate fluctuations.
1Over the past several years, major providers of fixed-income indexes have announced plans or have already started to add local Chinese bonds to some of their indexes. See, for example: “FTSE Russell announces results of Country Classification Review for Fixed Income and Equities.” FTSE Russell, Sept. 24, 2020. “Bloomberg Confirms China Inclusion in the Bloomberg Barclays Global Aggregate Indices.” Bloomberg, Jan. 30, 2019.
2Lockett, H. and Hale, T. “Beijing’s first bond offer to US investors draws record demand.” Financial Times, Oct. 15, 2020.
3Our measure of sovereign debt excludes agency securities. For China, our criteria mean we include central-government debt but exclude debt from policy banks.
4All yields are from MSCI-derived yield curves for each of the displayed sectors..
5The benchmark consists of bonds with time to maturity between seven and 10 years and an allocation of 40% market-value weight in U.S. Treasurys, 25% weight in eurozone sovereign bonds, 25% in Japanese government bonds and 10% in U.K. gilts.
6The other countries in the benchmark were underweighted proportionally.
7The factor model is calibrated using a one-year half-life for volatilities and a three-year half-life for correlations.
8Looking at active portfolio risk results in generally similar conclusions. Active risk is the projected annualized volatility of the difference in returns between the portfolio and the benchmark.
9 The measure of inflation we use includes price increases on a broad basket of goods and services. This contrasts with alternative measures of inflation that exclude price changes from energy and food.