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05 April 2022

Chinese Government Bonds: An Alternative Safe Haven?

2022 has so far proved difficult to navigate. The turn of the year brought with it multi-decade-high inflation figures stoking fears that a significant tightening of central bank liquidity was imminent, leading to a strong sell-off across growth markets with the tech-heavy Nasdaq crashing 14% in January alone. Just as investors began to come to terms with a tightening of financial conditions, as markets priced in six interest rate hikes for 2022, Russian troops stormed across the Ukrainian border. The economic sanctions that followed have created a confusing environment for investors. The abandonment of Nord Stream 2 and curbs against the purchase of Russian oil have led to a European energy crisis with rapidly rising costs further intensifying inflationary pressures globally. For some, this further strengthens the case for a tightening of liquidity to prevent inflation from becoming embedded into long-term expectations. For others, the deflationary impact of a pull-back in global trade means that a tightening of any financial conditions should be paused to avoid plunging economies into stagnation.

During times of uncertainty, investors have always flocked to safe-haven assets with the two most common choices, Gold and US Government Bonds, often taking centre stage. The yellow metal is viewed by many as the ultimate store of value during periods of market stress and when inflation bites. The US Dollar price per ounce has rallied 5.5% year-to-date, providing investors with adequate protection against tumbling equity markets. The HANetf Royal Mint Physical Gold ETC aims to track the spot price of physical gold and has returned 8.29% over the same period, additionally benefiting from a strengthening of the US Dollar against the Pound.
 
The performance of US Government Bonds has been mixed. Returns have varied across the curve as investors have found protection at the short end but have been punished at the long end. The iShares USD Treasury Bond 1–3-year ETF has delivered 3.11% over the past month whereas the iShares USD Treasury Bond 20+ years ETF has lost 2.52% over the same period. This divergence is likely explained through the long-dated instrument’s greater sensitivity to interest rates.
 
Looking beyond the events of the past month, investors are increasingly questioning the effectiveness of US Government Bonds and other developed market government bonds as safe-haven assets. Over a decade of extreme monetary policy has resulted in a dreary backdrop of low or even negative-yielding government bonds and the coordinated nature of quantitative easing (QE) programs has also increased correlations between countries, making it more difficult for investors to diversify risk. No doubt developed market government bonds will always retain a place within diversified portfolios, but extreme events of recent times have presented an alternative option for investors in the form of Chinese Government Bonds (CGBs) that could partner a traditional safe-haven allocation.
 
Historically, CGBs would typically be categorised as emerging market government debt rewarding investors with superior yields at the cost of volatility and greater risk of default. Such categorisation may no longer be justified. In recent times, CGBs have continued to provide a yield that is elevated when compared to developed market government debt but with lower levels of volatility relative to their emerging market equivalents. In addition, China has demonstrated both a strong ability and capacity to service its debt. China remains a net creditor to the rest of the world with a significant net foreign asset position, such creditworthiness is reflected in the country’s A+ credit rating, sitting only two ratings behind the UK Government.
 
This divergence in yield partnered with lower relative levels of volatility creates an attractive risk-adjusted return profile. Since the initial onset of the COVID-19 pandemic two years ago, CGBs have gained 20%, providing similar returns to Gold with lower levels of volatility while comparable US Government Bonds have lost 5% over the same period. CGBs have also provided investors shelter during recent market turbulence. The iShares China CNY Bond UCITS ETF provides diversified exposure to CGBs and has returned 3.28% over the past month, a return profile similar to that of short-dated US treasuries.

China’s currency, the Renminbi, also appears to be strengthening its position on the global stage. The Chinese Communist Party has set a goal to increase the stability of the currency through increasing its use in international trade and store of value within international capital markets. The currency has held firm since the invasion of Ukraine, briefly touching a four-year high against the Dollar, and there is increasing evidence of the Renminbi’s strengthening position within global trade with reports that Saudi Arabia is in active talks with China to begin to price a portion of oil sales in the currency.
 
As always, investments in the Chinese economy are not without risk. By design, China’s capital markets are not purely market-driven and thus investors need to remain vigilant. However, as the Chinese economy transitions from an export-driven economy to one focused upon domestic consumption, there will be an increasing desire for foreign ownership within capital markets to make up the current account shortfall from reduced exports.
 
A factor that cannot be ignored is China’s low environmental, social and governance (ESG) score due to its poor human rights record, elevated levels of corruption and high levels of pollution. While policymakers have made progress within this area, until significant improvement is made, CGB’s are unlikely to be appropriate for ethically-minded investors.
 
The volatility markets have experienced in recent times has delivered a timely reminder to investors of the importance of holding insurance within portfolios. The tried and tested methods of the past continue to deliver but policy choices of the last decade may have reduced their relative effectiveness. By incorporating CGBs investors gain an alternative haven that delivers a robust return profile largely uncorrelated to traditional options.

Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. The value of investments and any income derived from them may go down as well as up and you could get back less than you invested.

This article was taken from the March 2022 issue of Market Insight. To subscribe to our investment publications, please visit www.redmayne.co.uk/publications.
 
Chinese Government Bonds:  An Alternative Safe Haven?
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