The difference hedging costs make for China bonds

The dramatic drop in hedging costs increases attractiveness of onshore China bonds for USD-based investors. Concerns with the yield differential narrowing between US Treasuries and China government bonds, recurring and economically restrictive COVID related lockdowns, property market crisis worsened by pockets of mortgage boycotts, and rising geopolitical tensions have impacted investor appetite for onshore Chinese yuan (CNY) denominated China bonds.

As a result, from an asset allocation perspective, many investors have chosen to curb their China exposure as a whole. Foreign investment in the China bond market has dropped for five consecutive months at the end of June, according to data from China Central Depository & Clearing Co.—a reversal from years of growing international interest and investment in this asset class.

We believe it is also important to look beyond the news headlines. Did you know that onshore China bonds are the only major bond market to deliver a positive return in local currency terms in the first seven months of 2022 (according to data from Bloomberg Finance L.P.)?

In fact, onshore Chinese bonds have delivered the best performance year to date and over the trailing year, outperforming other world bond markets as of the end of July. Their low volatility and low correlation with other major asset classes have shown that onshore China bonds can be an effective portfolio diversifier as clients benefited from such returns.

We still see Chinese bonds as a key standalone strategic allocation in a portfolio, especially for investors looking for attractive nominal yields and real yields. As long-term investors, we often advise to look past the immediate—short-term events and market mood—and focus on your goals for the long run. That continues to be tried and true, but we believe that there is one short-term development that is creating an advantage for onshore China bonds in the current climate: a dramatic drop in CNY hedging costs. Hedging the CNY against the US dollar (USD) turned net positive for USD-based investors in early June for the first time in two years, and it stayed positive as of the end of July.