15 Jul, 2021
US Treasurys' dominance persists even as China's bond market grows
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China's government bond market is increasingly important for international investors, but experts say it will not challenge U.S. Treasurys as a global haven asset anytime soon.
Attractive yields, reforms by Beijing in areas such as foreign ownership and inclusion of Chinese bonds in global benchmark indexes have raised the appeal of Chinese bonds.
"I prefer allocating to CGBs — Chinese government bonds — over U.S. Treasurys," Daryl Liew, head of portfolio management at REYL Singapore, said in an interview. "The continued inflows into the Chinese bond markets indicate that many other investors are also attracted by the relatively higher yield that Chinese bonds offer."
As of July 8, 10-year CGBs are offering yields of 3.05%, compared with just 1.33% for 10-year Treasurys. While some of that margin is lost through hedging costs, it remains an attractive proposition, particularly as there is no prospect of China defaulting and investors losing their money.
China opening up
U.S. Treasurys remain fundamental to investment fund managers' portfolios. The $19.121 trillion American government bond market is the deepest capital market in the world, offering enough liquidity that an investor will always be able to liquidate Treasurys to raise cash if they need to. Foreign investors held $7.07 trillion worth of Treasurys as of April.
While the market for Chinese government bonds is still small, for now, it presents a growing opportunity. China's onshore bond market — dominated by central government bonds priced in yuan rather than U.S. dollars — is the world's second-largest bond market, worth $7.1 trillion at the end of 2020, according to the Bank of International Settlements. Of that, foreign investors now hold $568 billion, according to China Bond Connect.
Chinese bonds are also attractive because of their low correlation of performance with other asset classes, making them a good diversification for portfolios.
"China's economic and monetary policy cycles will not be perfectly synchronized with other parts of the world, but influenced by conditions within China. That ought to lead to lower correlations between Chinese bonds and other markets," Angus Hui, head of Asian credit at Schroders, said in an email.
The ability to access that market is also improving. China is keen to draw in foreign investors to help make the market more efficient, with demand for assets driving prices accordingly. In recent years Beijing authorities have dismantled ownership limits, quota systems and other impediments that had held back the development of China's bond market.
That has encouraged widely tracked indexes such as the Bloomberg Barclays Global Aggregate Index — followed by $2.5 trillion of funds — and the FTSE Russell World government bond index — tracked by $2.5 trillion — to include Chinese bonds. HSBC anticipates foreign ownership of CGBs will grow from about 10% of the market to 14%-15% in the next couple of years.
"One measure of breadth and depth of the CGB market versus U.S. Treasurys is weightings in key aggregate investment grade indices," André de Silva, global head of emerging markets rates research at HSBC, said in an email, noting that the weighting of Chinese bonds in the Bloomberg Barclays Global Aggregate is 7.6% as opposed to 43% for U.S. bonds. That means funds that track the index need to allocate far more capital to U.S. bonds than Chinese.
"It is difficult to see this compete directly in terms of similar weights even in the medium term," de Silva said.
The internationalization of the renminbi — the official name of China's currency as a medium of exchange — will also be crucial. Investors need to be comfortable with a currency to hold the assets in that currency, rather than hedging and introducing currency risk. At the moment the renminbi still lags as an international currency.
The renminbi made up just 2.3% of global central bank reserves as of the fourth quarter of 2020, according to the IMF. By contrast, the U.S. dollar makes up about 59% of foreign currency reserves held by central banks, ahead of 21.2% for the euro, 6% for the Japanese yen and 4.7% for the U.K. pound sterling.
The United States' twin deficits
The American government has spent big in an effort to keep its economy going during the pandemic with multitrillion packages that have caused budget deficits and debt levels to surge. The Federal Reserve has also resorted to unusual methods to sustain low borrowing costs, slashing interest rates and hoovering up trillions of dollars of assets through quantitative easing.
REYL's Liew suggests that the U.S. position as a safe haven could erode if rising inflation causes a correction in markets. "The unorthodox monetary policy and rampant fiscal spending being employed by the US has raised legitimate questions about the strength of the greenback and whether U.S. Treasurys will be able to hold up in a risk-off move in markets," Liew said.
HSBC's de Silva disagrees, arguing that the commanding reserve currency status of the dollar and the dollarization of global capital, trade and commodities will enable Treasurys to preserve their safe haven status.
"It is difficult to see this apply to the People's Bank of China at least for the foreseeable future even if there is likely to be progress on some of these factors," de Silva said.