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China's Bonds Buck the Emerging-Market Trend

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07/12/2018 | 11:45am CEST

By Saumya Vaishampayan and Mike Bird

HONG KONG--When currencies tumble in developing nations, bond investors often rush for the exits. In China, the opposite is happening.

Bond prices continued to rise even after the yuan started to drop rapidly against the dollar and other major counterparts last month.

The yield on 10-year government debt, which moves inversely to prices, has fallen to 3.51% from 3.88% at the end of last year, according to Wind Info.

In emerging-market countries like Indonesia and South Africa, the opposite has occurred in recent months, following a more familiar pattern. Prices have fallen and the yield on a Bloomberg Barclays gauge of local-currency debt has surged to 7.5% as of Wednesday, from 4.5% at the end of December.

That illustrates the unusual dynamics of the Chinese market: In contrast to emerging destinations like Indonesia that are popular with foreign investors, it is overwhelmingly dominated by local buyers.

Foreigners own just 1.7% of China's $12 trillion local-currency debt market. And the main holders of this debt--domestic banks, insurers and mutual funds--are less affected by a falling yuan.

A sharp selloff in stocks and rising corporate defaults have also left Chinese owners with few alternatives, especially as capital controls restrict their ability to buy abroad. That means government debt serves as a haven, much like U.S. Treasurys do for global money managers.

"Because it's very much locally sponsored and held, you have institutions from government agencies to banks who do take a flight to those government bonds in times of risk off," said Eric Wong, a fixed-income portfolio manager at Fidelity International in Hong Kong.

Even foreign investment that does exist tends to be stickier, since it is still not that easy to buy, or sell, China's government debt in the first place.

As China's place in global bond portfolios grows, the country's debt could become more sensitive to the mood of international investors. But for now it is being bolstered by interest from a vanguard of foreign buyers, who are eager to buy in before their peers.

Overseas institutions were net buyers of Chinese government bonds for the 16th straight month in June. They boosted their holdings to a record 915 billion yuan ($138 billion), based on data going back to 2014, according to Wind Info.

Other central banks are starting to add yuan to their reserves, much of which is likely stashed in sovereign bonds. And Beijing has taken steps to open up. It recently allowed offshore investors to access the so-called interbank market, the main venue for fixed-income trading, through a Hong Kong trading link called Bond Connect.

Investors are also banking on eventual inclusion in major indexes, such as those run by J.P. Morgan, which should attract passive money and boost prices further. Bloomberg LP said in March it would add China to its Bloomberg Barclays Global Aggregate Index next year, adding that those bonds would eventually make up more than 5% of the benchmark.

"There's a lot of money trying to front-run this index inclusion," said JC Sambor, deputy head of emerging-market fixed-income at BNP Paribas Asset Management in London. He said he became positive on Chinese sovereign debt last year, anticipating growth would slow and the central bank would have to lower interest rates.

A key consideration is how much the currency will tumble, since that cuts into potential returns. For example, a government bond maturing in May 2023 has already returned around 4.5% for investors in yuan terms this year. Yet in dollar terms the return has been just 2.3%.

The last major depreciation in 2015 fed panic about financial stability. However, the central bank has slowed the yuan's decline in recent days and pledged to keep it largely steady.

Mr. Sambor of BNP Paribas said he thought the yuan selloff was over, and now owns bonds from the People's Republic on an unhedged basis--rather than guarding against exchange-rate moves by buying so-called currency forwards, for example. Others disagree.

"We're still advising clients to buy Chinese bonds, but also to hedge the currency," said Pierre-Yves Bareau, chief investment officer of emerging market debt at J.P. Morgan Asset Management in London.

"It's different from 2015 because policy makers really lost control at that time. This time it's a more clear easing directive, leaning against the tariffs" imposed by the U.S., he said.

For now, the lack of outsiders has advantages, according to some asset managers: While large, developed bond markets tend to move in sync, China's marches to a different drum. Edmund Goh, Asian fixed-income investment manager at Aberdeen Standard Investments, said investors should see it "as an independent market that can have a negative correlation to the rest of the world."

Write to Saumya Vaishampayan at [email protected] and Mike Bird at [email protected]

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