By David Roberts, Co-Portfolio Manager of the Nedgroup Investments Global Strategic Bond Fund

The rising duration contribution of China and Japan

US dollar bonds have long been the cornerstone of global bond indices, representing nearly 40% of the Bloomberg Global Aggregate index by duration contribution. This dominance is largely due to the substantial issuance by the US government and US-based corporations. Euro-denominated assets follow, accounting for approximately 20% of the index by duration.

The inclusion of Chinese yuan-denominated bonds in 2019 marked a pivotal shift in the index’s composition. These bonds now constitute around 10% of the market, positioning them to potentially overtake Japan as the third-largest entity in the near future.

Figure 1: China and Japan account for nearly a quarter of the market by duration

Source: Bloomberg

Given that China and Japan together account for a quarter of the global bond market duration, a fund with no exposure to these markets but maintaining a 5-year duration would be considered “neutral” relative to the rest of the index. This is an important consideration, especially when we see European funds extending their duration up to ten years in “Western markets”, while asserting they are following the index.

The end of DM bonds proxies for Japan and China?

For the past couple of decades, many investors have safely ignored Japanese bonds (JGBs) due to ultra-low yields and central bank control. Additionally, the low “beta” of JGBs meant that bond managers could replicate Japan exposure with smaller Western markets when needed.

In contrast, China divides investors. Many, ourselves included, remain wary of the protections available to bond holders in times of distress. Recent property market woes have not helped. Even bonds within the index have faced liquidity and transparency challenges .

Historically, the Chinese bond market has been highly correlated with the US bond market, allowing investors to offset Chinese risk by increasing their holdings of US Treasuries, similar to their strategy with Japan.

However, with these correlations now shifting, what does that mean for bond investors going forward?

Japan: inflation denial

For some time now Japanese inflation has exceeded the central bank’s target. To put this into perspective, the latest data shows Japan CPI at 3% compared to headline US CPI of 2.5%. Figure 2 illustrates the unusual trend of Japanese inflation outpacing US inflation in recent years.

With the US now cutting interest rates, bonds have been rallying. However, as of 27^th September 2024, a US Treasury investor received 1.5% per annum above inflation whereas a Japanese bond investor received 1.5% less inflation. This divergence highlights the changing economic landscape and implications for bond investors.

It’s worth noting that the Bank of Japan has kept yields low and inflation high to manage Japan’s huge debt burden, reflecting its lack of independence and role as a direct government agent. Indeed, they have been trying to do that for more than two decades. Despite the inflation problem and the lack of value for bond investors, the Bank of Japan refrained from raising rates post pandemic, only making minor adjustments to cash rates. Consequently, avoiding Japanese bonds based on pure value and fundamentals, has been a straightforward decision.

Recently, the ruling LDP elected a new leader, Shigeru Ishida, a supporter of hikes. Bond markets rallied before the vote, anticipating no immediate increases. After Ishida’s victory, the Yen strengthened and JGBs fell slightly, hinting at potential future changes. This aligns with our view.

China: shelter with not enough value

Many investors shy away from China. Information flow is light and liquidity questionable compared with other major markets. For example, Bloomberg quotes a bid/offer “spread” on ten year Chinese bonds as high as 0.5%. Compare that to Gilts or US Treasuries where there is close to zero bid/offer.

Ignoring all that, many find no value basis for buying Chinese bonds. The Chinese economy has been struggling. The Politburo is targeting a 5% annual growth rate which seems unlikely. Bond markets have rallied to unprecedented levels. The yield on 10-year Chinese bonds recently touched 2%.

But many domestic investors have been so worried about the stock market they sought shelter in bonds. Some bought bonds on a trading basis, expecting the PBOC to slash interest rates as inflation remained barely positive. Instead, the authorities unveiled a package of fiscal measures designed to improve the housing market and feed directly into consumer confidence and consumption. The presumption that interest rates would be cut aggressively proved false. And of course, all that stimulus led equity markets higher meaning the chance of making more from the bond than the equity market faded.

27^th September saw record one day losses for holders of long maturity Chinese bonds. Even 10- yields rose by the most in several years (see Figure 3), wiping out several months’ worth of gain. Irrespective of politics, the lack of value suggests they are best avoided.

Outlook: greater core bond opportunities elsewhere

Buying Japanese or Chinese sovereign debt is hard to justify at current levels. Japan is either embarking on a path of monetary tightening or faces rising yields as the Bank of Japan is deemed further behind the curve. Meanwhile, Chinese yields are at levels never seen before with a wave of fiscal stimulus hitting the economy. Bond holders should brace themselves for a rocky ride with these assets. For now, we prefer to focus on core bond opportunities elsewhere.

Disclaimer

This article is of a general nature and intended for information purposes only, it is not intended for distribution to any person or entity who is a citizen or resident of any country or other jurisdiction where such distribution, publication or use would be contrary to law or regulation.  Whilst all reasonable steps have been taken to ensure that this article is accurate and current at the time of publication, we shall accept no responsibility or liability for any inaccuracies, errors or omissions relating to the information and topics covered in this article.

The opinions expressed within the article are considered to be correct and informed at the time of writing, but may be subject to change or amendment at the discretion of the Investment Manager without notice.

Nedgroup Investment (IOM) Limited (reg no 57917C), is licensed by the Isle of Man Financial Services Authority.

Nedgroup Investments (UK) Limited is regulated by the Financial Conduct Authority.