The coronavirus outbreak is rattling the markets. However, the Chinese bond market has done well during the crisis. We talked to Stephen Jen, CEO and Co-CIO of Eurizon SLJ Capital Limited, about the reasons and the characteristics of the world’s second largest bond market.
AsiaFundManagers.com: What developments have you seen since the coronavirus outbreak in the Chinese onshore bond markets?
Stephen Jen: The Chinese onshore bond market has behaved more like a DM bond market than an EM bond market: when times get tough, bond yields fall. Other EM bonds tend to behave like ‘credit’ in response to negative shocks. This has made the highly-rated bonds in China a fantastic safe haven in times of stress.
One key reason is that Chinese investors, who possess huge financial assets, are not permitted to go overseas. Thus, capital flight is not possible, even if there is such a desire to expatriate from China. This means that the negative correlations between bonds and equities inside China have been preserved, unlike the case in much of the DM markets.
AsiaFundManagers.com: Bond spreads have widened. How do you expect default rates in China to develop?
Stephen Jen: Even though bond yields (Central Government Bonds, Local Government Bonds, bonds issued by the Policy Banks, and bonds issued by super-sized state-owned enterprises) have behaved very well, as mentioned above, credit spreads have indeed blown out in some sectors and cases.
First, the credit spreads in general, prior to 2020, were unreasonably compressed and narrow, due to a variety of technical reasons and a prevalent (what we believe is false) assumption of a blanket government guarantee on credits. So, some normalization was expected to happen, sooner or later.
Second, the economic slowdown in China has been sharp, and the subsequent recovery may be hampered by weak global demand as well as broken supply chains. Consumers in China will also likely be reluctant to fully and quickly return to normality, until the virus is completely eradicated.
Cash flow pressures, top-line revenue pressures, and less than aggressive policy stimulus in China will indeed likely lead to mounting pressures on some credit names, and we do expect there to be a few (not too many) defaults.
However, we would take this development as a positive step, from a structural perspective, as some level of risk being imparted into the Chinese credit market ought to be a healthy development than a market with an artificially suppressed risk profile.
AsiaFundManagers.com: The Chinese government has so far been very reluctant to take fiscal measures. What can we expect here?
Stephen Jen: That is correct. It is a widely accepted view that Beijing made a policy error in 2008-09 in providing so much stimulus that helped fuel the property bubble and leverage in general. Since early-2018, Beijing has tried hard to refrain from policy stimulus and effect de-leveraging and de-risking without pricking the property bubble.
This notion that China needs to continue to wring the excesses out of its banking sector, the property markets, and leverage in general is still very much on the top of the Chinese policy makers’ minds. Of course, it is now also urgent for Beijing to prevent China from falling into a deep recession, but it has so far resisted following other countries’ (the US and Europe) footsteps in providing huge stimulus.
Thus far, the announced fiscal stimulus is relatively modest – less than half that of most countries in the west, and monetary stimulus remains orthodox and incremental.
I believe investors ought to expect Beijing to be less eager to stimulate the economy. If and when they do so, it will be ‘passive’ in nature, not proactive like in the West.
AsiaFundManagers.com: The Chinese bond market seems to be attracting massive amounts of international money right now. Is China the new safe haven?
Stephen Jen: The capital flows into this market have indeed been very encouraging, and logical. They are large but they could be and should be much larger. We believe the world is moving in the right direction in considering the already second-largest bond market in the world as a viable investment option.
The price characteristics of the RMB bonds, as argued above, have been exceptional. The RMB bonds, along with the US Treasuries and gold, are among the very few assets in the world that have delivered positive returns this year.
At the same time, the Chinese RMB has also behaved very well. Despite the sharp economic slowdown, the RMB has been stable vis-à-vis the strong dollar and has out-performed the EUR.
AsiaFundManagers.com: Where do you currently see buying opportunities in the Chinese bond market?
Stephen Jen: We believe that, when investors from Europe become more active in this market, it will be very important for them to stay safe and liquid. In fact, safety (low default risks) and liquidity (large trading volumes) are our focus, in the running of our RMB bond fund.
As mentioned above, the economic slowdown will likely accelerate the structural transformation of the credit market in China to allow a generally wider credit spectrum for yields to properly reflect the underlying risks of the companies in question. This means that there will be a transition period where some credit names will come under pressure, which investors ought to avoid. Next is liquidity. There are big portions of the Chinese bond market where the bonds are not active in the secondary market. Foreign investors ought to exercise care to also avoid these pockets of quicksand.
AsiaFundManagers.com: You manage one of the largest China onshore bond funds in Europe. How do you align the portfolio in the current market situation?
Stephen Jen: We believe the Chinese economy will struggle this year, as growth will remain low (i.e., 2%, not 5%). There will likely be a U-shaped recovery in H2 but the vigor of this prospective expansion will be constrained by a relatively weak rest of the world.
Now that the Fed has re-adopted ZIRP (zero interest rate policy), the RMB bonds now really enjoy a healthy yield premium over all bonds issued by DM countries, and will likely attract continued inflows, which should help to weigh on the sovereign bond yields.
We like Policy Bank bonds and believe the bonds of large SOEs will deliver the return characteristics we look for: decent yields, safety, and liquidity.
AsiaFundManagers.com: Thank you very much for the interview.
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CEO and Co-CIO
Eurizon SLJ Capital Limited
Stephen Jen is the CEO and Co-CIO of Eurizon SLJ Capital Limited.
From 1996-2009, Stephen was MD at Morgan Stanley and held various roles, including Global Head of Currency Research and Chief Global FX and EM Strategist. Prior to this Stephen was an economist with the IMF in Washington, D.C. covering Eastern Europe and Asia economies, and was actively involved in the design of the IMF’s framework to provide debt relief to highly indebted countries.
Stephen holds a PhD in Economics from the Massachusetts Institute of Technology with concentrations in International and Monetary Economics and earned a BSc in Electrical Engineering (summa cum laude) from the University of California, Irvine.
Eurizon SLJ Capital Limited is an asset management firm based in London established in April 2011 specializing in EM bonds, RMB bonds, and currency management. Eurizon SLJ is majority-owned by the Intesa Sanpaolo Banking Group in Italy.