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posted on 09 March 2016

China Bonds: Good For China, But Not Your Portfolio

by Ben Shepherd, Investing Daily

Investing Daily Article of the Week

While we don't have China-related stocks in our portfolio now, I've followed China closely for years now. With the world's second-largest economy since 2009, China has quickly become the bellwether for growth not only in the emerging markets, but the rest of the world.

Even if you don't actually own any Chinese stocks, China's stock market has a huge impact on your portfolio's performance. Its crashes since the summer have rocked world markets.

And now Chinese bonds will be another big factor to consider.

Last week's the People's Bank of China (PBOC) announced it's opening the country's bond market to an almost unlimited swathe of investors. China's $7.5 trillion bond market is the third-largest, behind the U.S. and Japan. Despite that, foreigners own less than 2% of the country's outstanding bonds thanks to strict capital controls. By contrast, foreigners own roughly 43% of outstanding American bonds

Why does that matter? Stability.

As the Chinese economy has radically cooled off over the past couple of years, a lot of folks have justifiably castigated the Chinese for running such a closed and controlled economic system. When governments can pick and choose which sectors it wants to encourage and which to cool, or which investors it wants to just outright exclude, it doesn't exactly encourage investor confidence.

It also makes it extremely tough to gauge how much of the turbulence in the Chinese economy is structural and how much is cyclical. So when a government like that takes even an incremental step towards opening up or loosening control, investors should take note, especially when it is the second-largest economy in the world.

Under the guidelines that the PBOC has released, about the only people who would find themselves still out of the Chinese bond markets are hedge funds and speculators. While that's still two more restrictions then I'd like to see, virtually every other sort of investor - including foreign governments and their sovereign wealth funds - will soon see a welcome mat where the was once a no trespassing sign.

China isn't loosening its grip on its debt market because it wants to be more accountable, though. It mainly because capital is stampeding for the exits, driving property bubbles in Canada and boosting asset prices in other areas as Chinese investors want to own anything other than Chinese assets. The Chinese government's hope is that by opening the doors to its capital markets to foreigners, it will draw more money in than is going out. It also means that you will likely soon be seeing Chinese bonds in your world bond mutual funds since they'll soon be eligible for inclusion in those benchmarks.

Will this latest move stabilize the Chinese economy tomorrow? Not by a long shot, if for no other reason than will take some time for foreign bond investors to wrap their heads around what's going on. But allowing greater foreign access to Chinese capital markets will help lend stability to what is a globally important economy down the road, making it less likely that we'll be blaming the Chinese for roiling the markets in the future.

In terms of our own recommendations, you aren't likely to see any Chinese bonds in our Global Income Edge portfolios anytime soon. There is already a very slim subset of them available to American investors, colloquially known as dim sum bonds, which you can access through mutual funds and ETFs. They're tailor made for foreign investors, but my particular approach to foreign investing is similar to my approach to foreign dining: eat what the locals eat.

It will take some time for investors to have access to truly local Chinese bonds, if for no other reason than it will take some time to build out the retail trading infrastructure. In the meantime, we'll benefit from the stabilizing effect of foreign institutional money moving into the market.

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