Chinese Bonds Deliver Double-Digit Returns, More Gains Expected

Chinese bonds have delivered strong performance over the past decade, with returns of over 15% on a currency hedged basis for EUR-based investors, and over 25% for USD-based investors. This performance compares favorably to other emerging market bonds, such as euro zone investment grade bonds, which lost 2.7% over the same period, and euro zone government bonds, which suffered a loss of over 7%. Indian bonds also outperformed in Q1 2024, helped by a resilient rupee.

In terms of volatility, Chinese bonds have lower volatility than many developed and major fixed income markets. For example, the annualised volatility of the Bloomberg China Agg index is 1.60% for USD hedged and 1.60% for EUR hedged, compared to 8.90% for USD-hedged US high yield and 9.20% for USD-hedged US corporate bonds.

These data points suggest that Chinese bonds have offered attractive returns with relatively low volatility compared to other emerging market bonds over the past decade.

The key factors driving the strong performance of Chinese bonds are:

1. Easy Monetary Policy: China's monetary policy has been loose, in contrast to aggressive tightening by other major central banks. This has led to lower interest rates and attracted investors to Chinese bonds.
2. Domestic Safe-Haven Inflows: The stable performance of Chinese government bonds (CGBs) has drawn domestic safe-haven inflows, further boosting their performance.
3. Cyclical Recovery: A recovery in the world's second-largest economy is likely to be steady yet slow, which should support Chinese bond yields.
4. Low Inflation: Domestic headline inflation remains well below the official 3% target, which keeps monetary policy supportive for yields.
5. Structural Factors: Chinese onshore bonds represent a defensive investment, providing an anchor for a global portfolio with the potential for attractive returns that are uncorrelated with other major government bond markets.

These factors differ from other emerging market bonds in several ways:

1. Monetary Policy Divergence: While many emerging markets have followed a tightening path, China has maintained an accommodative monetary policy stance.
2. Inflation Dynamics: China's low inflation environment contrasts with the sticky inflation pressures experienced in other major economies.
3. Safe-Haven Status: Chinese bonds have served as a safe-haven investment for domestic investors, unlike many other emerging market bonds.
4. Cyclical Recovery: The steady yet slow recovery in China's economy differs from the more volatile growth patterns seen in other emerging markets.
5. Structural Attractiveness: Chinese onshore bonds offer unique structural benefits, such as diversification and low correlation with other major bond markets, which are not as readily available in other emerging market bonds.

The interest rate differentials between Chinese bonds and other emerging market bonds can significantly impact their relative performance. In the report "Fixed Income Insights (China) – April 2024," it is mentioned that Chinese sovereign yields fell across the curve in Q1, as onshore spreads narrowed. This indicates that Chinese bonds have become more attractive compared to other emerging market bonds, as their yields have decreased while the yields of other emerging market bonds have remained relatively higher.

Additionally, the report highlights that Asian yield moves were mixed, with Chinese spreads versus G7 falling back in Q1. This suggests that Chinese bonds have outperformed other emerging market bonds in terms of yield differentials. The narrowing of spreads and the fall in yields have made Chinese bonds more appealing to investors, as they offer higher returns compared to other emerging market bonds with similar risk profiles.

Furthermore, the report notes that Indian bonds outperformed in Q1, while JGBs lagged on a weaker yen and monetary tightening. This comparison further emphasizes the impact of interest rate differentials on the relative performance of bonds from different emerging markets. In this case, Indian bonds outperformed due to a resilient rupee and stable interest rates, while Japanese government bonds (JGBs) underperformed due to a weaker yen and monetary tightening.

In conclusion, the interest rate differentials between Chinese bonds and other emerging market bonds play a crucial role in determining their relative performance. As Chinese bonds have experienced a decrease in yields and narrowing spreads, they have become more attractive to investors, leading to outperformance compared to other emerging market bonds.