CHINESE GOVERNMENT DEBT: FROM TACTICAL TO STRATEGIC ALLOCATION

June 18, 2022 | 9 Minute Read

The outperformance of China government bonds (CGBs) relative to other developed market (DM) government debt has been substantial year-to-date¹. That said, the yield pick-up attractiveness of CGBs relative to US Treasuries has now vanished. This has created hesitancy among some investors looking to allocate to CGBs for the first time, while others have tactically reduced their exposures. Crucially, we believe the strategic long-term case for including CGBs in global fixed income portfolios remains intact. In fact, it is our view that China’s dovish policy shift has made the case for CGBs even more compelling. Importantly, China’s integration into the investment mainstream indices means both active and passive investors may be expressing views on the asset class, whether intentionally or not. More recently, two questions appear to be top of mind among our clients:

1. To hedge or not to hedge the FX exposure?

2. How effectively are CGBs able to diversify global fixed income portfolios?

We provide our responses to both questions in detail below, explaining why our preference is to not hedge CGB exposure and why we believe this unique asset class can potentially help build more efficient portfolios.

To Hedge or Not to Hedge the FX Exposure?

In order to answer this question, we look at the performance CGBs in local currency terms and across four major currencies: USD, EUR, GBP, and Swiss franc (CHF). In terms of FX, we conclude based on past performance that not hedging while adding volatility can result in greater returns and low correlation, thus significantly improving the efficient frontier (i.e., higher returns per unit of risk) of portfolios built with CGBs compared to portfolios that do not include CBGs. The Chinese Yuan (CNY) has appreciated against the aforementioned currencies year-to-date, with the highest appreciation versus EUR and GBP, and the lowest versus CHF.

Our long-term outlook for CNY remains constructive due to a multitude of factors; including our expectations for an acceleration of foreign investment flows into CNY assets due improved market access, liquidity and tradability of CGBs, and China’s inclusion in global bond indices. Additionally, we expect CNY’s modest share of global (ex-China) central bank reserves to rise over the long term, alongside China’s weight in the International Monetary Fund’s (IMF) Special Drawing Rights (SDR) basket. In the absence of a negative CNY outlook, we ultimately conclude that is preferable to not hedge CGBs.

Exhibit 1: CGBs Have Performed Strongly

Source: Bloomberg and GSAM. As of 1-May-2022. Analysis from Apr-2017 to Apr-2022, monthly data. All indices rebased to 100. RFR = 0. China is represented by the FTSE Chinese Government Bond Index, unhedged. Global Agg ex-China is represented by the Bloomberg Barclays Global Agg Bond Ex-China Index, hedged. Past performance does not guarantee future results, which may vary.

CGBs in local currency terms have performed relatively strongly over the last five years with a solid 4.2% annualized return—a superior performance compared to the Bloomberg Global Aggregate Index (ex-China), which printed a negative performance in EUR, GBP, and CHF and a 1.4% return in USD (Exhibit 1). Moreover, the risk-adjusted performance of CGBs stands out given the modest volatility of 2.3%, lower than the Bloomberg Global Aggregate Index (ex-China). In hard currency terms, investors in USD, EUR, GBP, and CHF would have performed even better and gained significant additional returns for the FX risk being taken, with annualized returns ranging from 4.6% to 5.7%.

Diversification Benefits of CGBs in Fixed Income Portfolios

CGBs not only have attractive risk-adjusted returns, but the asset class has close to zero correlation to the Bloomberg Global Aggregate Index and the most common fixed income assets (Exhibit 2). Low correlation and attractive risk-adjusted returns can be the building blocks of more efficient portfolios. Indeed, Exhibit 3 illustrates how adding CGBs to well-diversified fixed income portfolios has historically significantly improved the efficient frontier. The purple line on the right-hand side chart shows the efficient frontier in a world in which CGBs do not exist, or cannot be invested in, while the “all assets” line above is the efficient frontier including CGBs with all the other assets. Furthermore, CGBs have a negative correlation to Chinese domestic stocks (China A-shares) making the asset class a great diversifier for investors exposed to China’s equity market.

Exhibit 2: CGBs Have Low Correlation to Major Bond and Equity Markets

Source: GSAM, Bloomberg. As of 31-Dec-2021. Correlations based on weekly returns for the last 5 years. Past correlations are not indicative of future correlations, which may vary. LHS Chart uses on the run 10 year government. RHS Chart Indexes used: FTSE China Government Bond Index, Bloomberg Barclays Global Aggregate, MSCI China A Onshore Index, JP Morgan GBI-EM Global Diversified Composite, Bloomberg Barclays Global Aggregate Corporate, Bloomberg Barclays US Corporate High Yield,, Bloomberg Barclays US Treasury Index, S&P 500 Index. For illustrative purposes only.

Exhibit 3: CGBs Can Help Build More Efficient Portfolios

Source: Bloomberg, Datastream, Haver Analytics, Goldman Sachs Global Investment Research, and Goldman Sachs Asset Management. As of 18-Mar-2022. Analysis from Jan-2016 to 13-Mar-2022. CGBs: Bloomberg EM Local Currency - China; GBI-EM: JPM GBI-EM Global Diversified; EMBI: JPM EMBI Global Diversified; USTs: Bloomberg US Government; EGBs: iBoxx EUR Sovereigns; JGBs: Daiwa Bond Index – Government Bonds; Gilts: iBoxx GBP Gilts; USD Corp HY: iBoxx USD Liquid High Yield; USD Corp: IG: iBoxx USD Liquid Investment Grade; EUR Corp HY: iBoxx EUR Liquid High Yield; EUR Corp IG: iBoxx EUR Liquid Corporates. Past performance are not indicative of future performances, which may vary. This analysis uses historical weekly return data. Hedging is computed using 3-month FX forwards. The efficient frontier is the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. Portfolios that lie below the efficient frontier are sub-optimal because they provide lower returns for a similar level of risk. Portfolios that cluster to the right of the efficient frontier are sub-optimal because they have a higher level of risk for the defined rate of return.

In a world where the traditional 60-40 portfolio model is being challenged, particularly in 2022 where both core equity and core fixed income exposures have detracted, we regard CGBs as a compelling long-term investment opportunity. We believe the asset class can be a favorable addition to portfolios by bringing a new source of diversification and improving risk-adjusted returns. However, it’s important to highlight that those results are based on historical data, correlations and diversification benefits may vary in particular as foreign investor flows to CGBs increase. To conclude, as we have previously stated, our view is that China has become too big to ignore for global fixed income investors.

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¹ Source: S&P Dow Jones Indices and FTSE Russell. As of July 7, 2022.

Glossary
wiss franc (CHF)- ECB euro reference exchange rate, as defined by the European Central Bank.

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Efficient frontier analysis determines minimum variance portfolios for a range of return targets. The analysis is contingent on a priori assumptions about return, risk, and correlation for the subject asset classes and the results can be very sensitive to small changes in these assumptions. There is no industry standard method for developing these assumptions and practices vary widely. Efficient frontier analysis may not take into account material economic and market factors. The results are hypothetical and do not reflect fees, transaction costs, and other expenses, which would reduce returns. Actual results will vary.

Supplementary Performance Data

Annual Returns	CGB (CNY)	CGB (USD)	CGB (EUR)	CGB (CHF)	CGB (GBP)	Glb Agg ex-China USD	Glb Agg ex-China EUR	Glb Agg ex-China CHF	Glb Agg ex-China GBP
12 Months ending April 2018	3.3%	12.2%	1.0%	11.7%	5.5%	1.4%	-0.8%	-1.3%	-1.3%
12 Months ending April 2019	4.6%	-1.4%	6.3%	1.5%	4.0%	5.4%	2.3%	1.9%	2.2%
12 Months ending April 2020	9.3%	4.2%	6.9%	-1.1%	8.1%	8.2%	5.4%	4.9%	6.7%
12 Months ending April 2021	-0.9%	8.1%	-1.7%	2.1%	-1.7%	0.2%	-0.7%	-1.0%	0.0%
12 Months ending April 2022	4.7%	2.6%	17.0%	9.3%	12.8%	-7.5%	-8.5%	-8.7%	-7.8%

Past performance does not guarantee future results, which may vary. The value of investments and the income derived from investments will fluctuate and can go down as well as up. A loss of principal may occur.

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Our In-Depth Commentary Could Help You Gain a Competitive Edge

CHINESE GOVERNMENT DEBT: FROM TACTICAL TO STRATEGIC ALLOCATION

To Hedge or Not to Hedge the FX Exposure?

Exhibit 1: CGBs Have Performed Strongly

Diversification Benefits of CGBs in Fixed Income Portfolios

Exhibit 2: CGBs Have Low Correlation to Major Bond and Equity Markets

Exhibit 3: CGBs Can Help Build More Efficient Portfolios

Related Insights

Navigating Agency Mortgages Through QT

Chinese Government Debt Demands A Decision From Active And Passive Investors Alike

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nnip title

Our In-Depth Commentary Could Help You Gain a Competitive Edge

CHINESE GOVERNMENT DEBT: FROM TACTICAL TO STRATEGIC ALLOCATION

To Hedge or Not to Hedge the FX Exposure?

Exhibit 1: CGBs Have Performed Strongly

Diversification Benefits of CGBs in Fixed Income Portfolios

Exhibit 2: CGBs Have Low Correlation to Major Bond and Equity Markets

Exhibit 3: CGBs Can Help Build More Efficient Portfolios

Related Insights

Navigating Agency Mortgages Through QT

Chinese Government Debt Demands A Decision From Active And Passive Investors Alike

Start the Conversation

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