YOUR GOALS,OUR COMMITMENT.

Time to reconsider Chinese bonds
Chinese bonds offer a valuable source of diversification from a global portfolio
perspective

Ian Chong, Senior Portfolio Manager
Chris Rands, Senior Portfolio Manager
Naomi Fink, Chief Global Strategist
4 July 2024

Global markets may be missing the obvious, quieter China trade
China has been making headlines lately, but not all of it has been positive. The country is facing challenges such as
the rise in global trade barriers, excess inventories of industrial materials (ranging from copper to solar panels), a
sluggish property market and slowing consumer demand. As a result, the stock market has been subdued. However,there may be an opportunity for investors to consider. Despite the negative news, global markets may haveoverlooked something important.
We believe
what is immediately apparent. In ourview, Chinese bonds are an asset class that provides good diversification opportunities within a global portfolio. They
also represent a relatively, thanks tocurrent account surplus and efforts to generate consumer
price rises in a world where others are struggling to keep inflation contained. As a result, it could be an error tooverlook Chinese bonds and indeed renminbi (RMB)-denominated bonds within a global portfolio when
considering both Chinese and global market dynamics.

China’s bond-friendly domestic dynamics
For retail investors, slower economic growth and low to negative inflation may not be appealing for equity
investments. However, these conditions can actually make bonds a more attractive option. Here are a few reasons
why:
Slow Chinese growthcurrently undergoing government-led restructuring, moving awayfrom real estate towards
manufacturing. Although this transition is expected to impact overall growth for now, it may be necessary given
the much larger size of the economy compared to the previous decade and an ageing population. As a result,inherently slower than we have been used to.
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TIME TO REVISIT CHINESE BONDS FROM A GLOBAL PORTFOLIO PERSPECTIVE

Low inflation: The impact of economic restructuring (especially the negative wealth effect and sentiment
related to falling home prices) and the lack of direct cash transfers to households during the pandemic have
led to slower demand and lack of inflationary pressures. Despite the slowdown over the last few years, China
has still managed to reserve room for monetary policy to support growth, should the need arise.
Measured fiscal stimulus: Fiscal policy is accommodative but measured, and we believe that the market could
absorb a slightly higher supply of government bonds without causing excessive volatility.
Very low probability of default: The likelihood of default, either externally or internally, by Chinese
government entities is very low, given factors such as high external surpluses. Althoughgross debt-toGDP (Gross Domestic Product) is high, much of this is denominated in local currency. Moreover, domestic
indebtedness has slowed, as indicatedCharts 1 and 2).
debt issuance has remained relatively controlled in recent years

12 (%)
10
8
6
4
2
0
2015

2016

2017

2018

2019

2020

2021

2022

2023

Source: WIND, Bloomberg, NBS, June 2024

C

Source: Macrobond, June 2024

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TIME TO REVISIT CHINESE BONDS FROM A GLOBAL PORTFOLIO PERSPECTIVE

Currency advantages: positive fundamentals for the RMB
The RMB benefits from China having a current account surplus, which can help it weather periods of investment
outflows. The currency has already corrected somewhat in 2022 against the CFETS (China Foreign Exchange Trade
System) index (a trade weighted currency basket) when China was hit hardest by the COVID-19 pandemic (Chart 3).
Additionally, the Chinese government has taken measures to mitigate volatility, creating more favourable conditions
for risk/return. Despite these advantages, the RMB is under-represented in global reserves. Therefore, the Chinese
government
to strengthen the domestic bond market could help support the recovery of Chinese domestic
demand.
Chart 3 : RMB vs CFETS (trade partner) basket
110

105

100

95

90

Source: Macrobond, June 2024

Trade tensions between the US and China may be on the rise, but there are signs of strengthening trade ties within
Asia (including Japan), which might also increase demand for RMB-denominated assets among reserve-holding
economies in the region.

Portfolio advantages: diversification through Chinese bonds
risk model (Table 1) depicts the unique characteristics of the Chinese bond market, with correlations
staying negative against most equity markets and only marginally positive against the traditional sovereign bondmarkets. Over the past three years, the Chinese monetary policy cycle has decoupled from the developed world, withfalling cash rates in China enabling its bond market to play a more traditional role in defensive portfolio allocation.
Additionally, as described above, the low inflation levels, slowing property sector and reduced growth trend imply
that these defensive characteristics are likely to persist as Chinese monetary policy will remain decoupled from
Western countries.

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TIME TO REVISIT CHINESE BONDS FROM A GLOBAL PORTFOLIO PERSPECTIVE

Table 1: Chinese bonds are a good diversifier

Asset

S&P500MSCI EUFTSE100

TOPIX

MSCI
LATAM
MSCI ENR(unhedged)

ASX200

US HY

EU HY

USTs 5-7YR

Germany
5-7YR

Japan 5-7YR China 5-7YR

EM LC
Gold
(unhedged)

S&P500100.0%

84.0%

69.0%

66.4%

76.5%

61.4%

58.6%

78.5%

70.8%

11.6%

17.2%

14.5%

-6.5%

54.9%

8.8%

MSCI EU

84.0%

100.0%

82.3%

70.5%

77.4%

60.6%

62.6%

74.6%

75.3%

3.1%

7.1%

7.1%

-12.4%

56.8%

3.0%

FTSE100

69.0%

82.3%

100.0%

56.3%

72.8%

60.0%

71.5%

64.7%

65.7%

-4.7%

-3.2%

-0.3%

-10.0%

48.8%

7.7%

TOPIX

66.4%

70.5%

56.3%

100.0%

56.8%

57.0%

49.5%

51.3%

53.6%

-23.6%-16.4%-16.8%-15.0%

68.8%

7.9%

ASX200

76.5%

77.4%

72.8%

56.8%

100.0%

59.0%

56.9%

73.4%

72.2%

4.8%

12.6%

14.9%

-14.6%

50.6%

6.5%

MSCI LATAM (unhedged)

61.4%

60.6%

60.0%

57.0%

59.0%

100.0%

62.8%

62.2%

59.5%

-23.8%-19.2%

-0.7%

-8.0%

70.3%

24.9%

MSCI ENR

58.6%

62.6%

71.5%

49.5%

56.9%

62.8%

100.0%

53.5%

51.7%

-23.9%-16.5%-10.7%

-2.5%

39.9%

4.5%

US high yield

78.5%

74.6%

64.7%

51.3%

73.4%

62.2%

53.5%

100.0%

90.6%

17.5%

23.4%

20.1%

-11.8%

46.8%

5.7%

EU high yield

70.8%

75.3%

65.7%

53.6%

72.2%

59.5%

51.7%

90.6%

100.0%

4.2%

13.6%

9.8%

-13.0%

48.3%

6.2%

USTs 5-7YR

11.6%

3.1%

-4.7%

-23.6%

4.8%-23.8%-23.9%

17.5%

4.2%

100.0%

77.4%

55.1%

16.2%

-21.0%-3.0%

Germany 5-7YR

17.2%

7.1%

-3.2%

-16.4%

12.6%-19.2%-16.5%

23.4%

13.6%

77.4%

100.0%

58.4%

17.5%

-19.7%-7.2%

Japan 5-7YR

14.5%

7.1%

-0.3%

-16.8%

14.9%

-0.7%

-10.7%

20.1%

9.8%

55.1%

58.4%

100.0%

12.6%

-4.7%

-4.1%

China 5-7YR-6.5%-12.4%-10.0%-15.0%-14.6%

-8.0%

-2.5%

-11.8%-13.0%

16.2%

17.5%

12.6%

100.0%-10.4%-9.5%

EM LC (unhedged)

54.9%

56.8%

48.8%

68.8%

50.6%

70.3%

39.9%

46.8%

48.3%

-21.0%-19.7%-4.7%-10.4%

100.0%

34.1%

Gold

8.8%

3.0%

7.7%

7.9%

6.5%

24.9%

4.5%

5.7%

6.2%

-3.0%

-7.2%

-4.1%

-9.5%

34.1%

100.0%

Source: Nikko AM, June 2024

This can be compared to the correlation between risk assets and US Treasuries, where the correlation to the S&P 500
has gone from negative to positive (Chart 4). Contrary to China, high inflation and rising cash rates in the US haveresulted in the performance of all financial assets becoming more similar, meaning that the traditionally defensive
asset once used to diversify risk is now contributing to an increase in portfolio volatility. Should inflation prove to be
stickier than the market currently expects, it would be reasonable to expect that this would keep the correlation
higher than it was over the past 20 years, leading to a more consistent relationship between equity and bonds thatthat is similar to what occurred in the 1990s. Chart 4 below depicts the shift that has occurred in the US Treasury
market over the past three years, compared to the US dollar, which has become a more defensive alternative.
Chart 4: Correlation between US Treasuries and the S&P 500 according to Nikko AM long-term risk model
0.5
0.4
0.3
0.2
0.1
0
-0.1

From negative to positive

-0.2
-0.3
-0.4
-0.5

UST 5-7YR vs S&P 500

US Dollar Index vs S&P 500

Source: Nikko AM, June 2024

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TIME TO REVISIT CHINESE BONDS FROM A GLOBAL PORTFOLIO PERSPECTIVE

Hedged or unhedged?
Currency-hedged bonds currently yield only marginal returns. Chinese bonds are no exception; for example, the 10year CGB yields approximately -0.40% for a Japan-based investor when hedged back to yen1. However, because theChinese yuan is managed against a basket of currencies with a high weighting for the dollar, the currency shows more
resilience against the strength of its US counterpart. Importantly, while US Treasuries have increased their correlation
to risk assets over the past three years, the dollar has retained its negative correlation as depicted above.
This implies that holding unhedged Chinese bonds can lead to increased diversification, depending on the basecurrency used by the investor. Table 2 below shows the effect of unhedged as well as hedged Chinese bonds for both
Japanese yen and Singapore dollar investors. Interestingly, for the investor using the Singapore dollar, removing thehedge on Chinese bonds leads to improved diversification against risk assets, while for the investor using the yen, it
results in strong levels of diversification against interest rate duration risk (notably US 5 to 7-year). This can offer
additional protection in the portfolio depending on the asset mix and can help improve yield by reducing hedging
costs.
Table 2: Effect of hedged, unhedged Chinese bonds according to Nikko AM long-term risk model
Asset
China 5-7YR (Hedged JPY Investor)
China 5-7YR (Unhedged- JPY Investor)
China 5-7YR (Unhedged- SGD Investor)

MSCI
LATAM
MSCI ENR(Unhedged)

S&P500MSCI EUFTSE100TOPIX

ASX200-6.5%-12.4%-10.0%-15.0%-14.6%

-8.0%

7.6%

11.2%

9.4%

45.9%

4.0%

24.8%

-33.9%-32.9%-32.7%-24.8%-32.2%-37.4%-26.8%

US 5-7YR

Germany 5- Japan
7YR
5-7YR

EM LC
(Unhedged)

US HY

EU HY

Gold

-2.5%

-11.8%-13.0%

16.2%

17.5%

12.6%

-10.4%

-9.5%

13.8%

-12.0%-3.8%-48.8%-33.9%-29.7%

53.9%

21.8%

-37.4%-34.5%

6.3%

12.9%

-5.8%

-19.7%-3.7%

Source: Nikko AM, June 2024
Note: this figure presents a heat map of diversification benefits in terms of weighted correlation between individual indices and an index of Chinese 5 to
7- year sovereign bonds, either (a) fully hedged into Japanese yen (JPY) or (b) unhedged versus (i) a portfolio with base currency of JPY and hedged unlessotherwise noted or (ii) a portfolio with base currency of Singapore dollar (SGD) and hedged unless otherwise noted. It is clear to see that for the SGDdenominated portfolio, holding China 5-7 year bonds un-hedged provides diversification benefits against equity risk, though less so for the JPYdenominated portfolio, which achieves better diversification benefit against equity risk from holding the bonds hedged.

Should we worry about the US fiscal position?
In the context of this report, the final point worth exploring is whether the US fiscal balance is sustainable with respect
to US Treasuries. Currently, the US government is running a fiscal deficit exceeding 5% of the GDP2, a deficit level thathas historically been seen only during recessionary periods. This high level of deficit will increase the government
debt burden, leading to greater bond issuance. As the International Monetary Fund (IMF) describes, this may makethe last mile of disinflation harder to achieve. If inflation remains high and the US government needs to issue a large
amount of bonds, it may be prudent to continue diversifying away from US Treasuries to avoid higher financing costs
which could make the debt trajectory unsustainable.
On the other hand, although China also has relatively high levels of debt, its general government debt-to-GDP ratio
remains lower than that of the US. Moreover,lower interest rates make servicing of interest costs moremanageable. While it remains unclear whether the US debt load will become unsustainable, from a global portfolio
perspective we believe that the diversification benefits on offer andlow inflation environment make thekey market to explore as an alternative to US Treasuries.

Conclusion: Chinese bonds offer a valuable source of diversification
As we have outlined above, there is not only a compelling case for Chinese bonds on their own merits, but also as avaluable source of diversification in a global multi-asset portfolio. Chinese bonds can provide diversification against
underperformed.

1 Source: Bloomberg, June 2024
2 Source: US Congressional Budget Office, June 2024

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TIME TO REVISIT CHINESE BONDS FROM A GLOBAL PORTFOLIO PERSPECTIVE

There is also a significant probability that Chinese bonds will continue providing good diversification value in the
future. This is due to the diverse macroeconomic dynamics between China and many developed bond markets,
notably the US. Meanwhile, the RMB may provide diversification in its own right. However, we believe that thecurrency diversification value it offers depends on the currency denomination of the underlying portfolio.

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