Brexit Volatility Highlights China Appeal by Brad Gibson, Alliance Bernstein

The widespread financial-market volatility that followed the Brexit referendum highlighted the relative attractiveness of a bond market many investors have yet to discover—China.

For active, global investors, market volatility can create opportunities to capture potential gains. This proved to be the case following Britain’s recent referendum on European Union membership, when victory for the “leave” campaign sent many markets into a spin.

While many investors focused on the gyrations in the British pound and the increasingly low or negative government bond yields in the region, others were drawn to the comparative calm of the Chinese bond market and the superior yields on offer.

Solid Metrics for Bond Market

This may seem surprising: after all, China is known these days at least as much for its growth slowdown, policy uncertainty and financial-system risks as it is for its long-term economic and social potential.

The government bond market, however, screens well on a number of metrics, including positive real yield, low relative volatility and low correlation to global bonds.

Just days after the UK referendum result, the Chinese government auctioned in the dim sum or Hong Kong-based offshore market bonds with maturities of three, five, seven, 10 and 20 years.

The yields were attractive. The 3.30% offered in the five-year maturity, for example, was high in comparison to developed-market government-bond yields (Display), and remained attractive even after the cost of hedging back to US dollars.

Brexit, Volatility, China

China Rating Matches UK, EU

It’s worth noting that, since the Brexit vote, the UK’s AAA sovereign rating has been downgraded two notches by Standard & Poor’s to AA—the same as China’s sovereign rating. The European Union’s rating has also been downgraded to AA.

In other words, the Chinese bonds offered higher yields than investors could get in the UK and core European markets, but for similar credit risk.

Good Outlook for Dim Sums

The outlook for these offshore or dim sum Chinese bonds is good, in our view. They are well supported in the market, as low net issuance by Chinese government agencies has created a favorable supply-demand dynamic. Year-to-date, issuance stands at RMB6 billion (US$900 million), back to what it was in 2009.

Also, China’s capital market reforms mean that the dim sum market will at some point converge with the domestic mainland market, where the five-year government bond is trading at 2.70%, or 60 basis points lower than the yield at which the equivalent bond was issued in Hong Kong.

As the markets converge, so will their yields with the much smaller offshore market moving to meet the onshore market. This means that buyers of the dim sum issue have virtually locked in a future price rise relative to the onshore market (bond yields move inversely to bond prices).

Renminbi Has Been Relatively Stable

While it’s true that China’s currency, the renminbi (RMB), has been volatile against the US dollar, this is mainly because the US dollar has been appreciating: when compared to other currencies, the RMB has been relatively stable (Display). The cost of hedging Chinese bond exposure is attractive for investors who are using these currencies and just looking for interest-rate exposure.

Brexit, Volatility, China

China’s bond market is not without risk, but risk is unusually elevated in many developed-country bond markets at the moment and nominal bond yields in many developed markets are at or below zero. In this context, China’s government bonds, whether offshore or onshore, offer a relatively attractive risk-reward proposition.

Just as importantly, they underline how an active global approach to investment can increase the scope for generating investment returns and managing risk, particularly during periods of volatility.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.