China Government Bonds: Unlikely laggards
- In 1H, expectations of CGB outperformance did not materialize
- Some positive economic data and the takeover of Baoshang Bank were behind the poor showing
- Having lagged in the global bond rally, CGBs now look quite cheap and offer decent roll down
- PBOC turning more accommodative. Bank funding rates are coming down and could support CGBs
- Implication for investors – stay bullish on CGB and expect better performance in 2H
The underperformance of China Government Bonds (CGB) in the first half of 2019 has caught investors by surprise (many had CGB as conviction ideas). Many held the view that the People's Bank of China (PBOC) has the will, the room, and the tools to ease to support economic activity. In addition, CGBs will enjoy a boost in foreign demand from inclusion into the Bloomberg Barclays Global Aggregate Index. But the CGB’s underperformed.
When we compare movements in CGB vs US Treasury yields and look at the timeline of events, we think the underperformance was largely due to two time periods. In April, China's economic data was picking up, leading to greater confidence that the economy had bottomed. Stocks surged. PBOC officials subsequently gave signals that they were going to dial back on stimulus. Over the month of April, 10Y CGB yields jumped 34bps vs UST's 10bps. In late-May, PBOC and China Banking and Insurance Regulatory Commission assumed control of Inner-Mongolia-based Baoshang Bank, citing serious credit risks. The event spurned concerns over the credibility of smaller banks and non-bank financial institutions. Many of these smaller institutions were holders of CGBs and used CGBs as collateral to borrow. They had to sell when their funding markets contracted and borrowing costs surged. In the last week of May, 10Y CGB yields fell 2bps vs UST's 19bps.
CGB are quite cheap now
Ytd, we have seen a strong rally in global fixed income on the back of expectations that global interest rates would be lower for longer. Many sovereign bonds have gotten quite rich and are now pricing in substantial monetary easing and rather downbeat economic scenarios. For investors late to the rally, the bar for price appreciation has risen to quite high levels (markets would need to assume recession or sharp growth slowdown for bond prices to rally further). In contrast, CGB yields have lagged the rally (10Y tenor unchanged year-to-date), making it relatively cheap. 10Y CGBs now yield a massive 130bps over US Treasury and the CGB curve still offers decent roll down. In a world where positive yields and steep curves get increasingly scarce by the day, CGBs look compelling.
Interbank liquidity conditions are a key factor in the outlook for CGBs (ownership is dominated by domestic banks). Since April, PBOC's liquidity interventions in the banking system has clearly turned more accommodative. Consequently, bank funding rates are coming down and could drive CGB yields lower in the months ahead. Furthermore, with economic momentum still weak, PBOC could make further reductions to the required reserve ratios, freeing up funds that could go to purchasing CGBs.
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