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Category Archives: Asset Allocation

China issues in hard currency!?

05 Tuesday Nov 2019

Posted by beyondoverton in Asset Allocation, China, Debt

≈ Leave a comment

Why do smart people do obviously ‘irrational’ things? It must be the incentive structure, so for them they do not seem irrational. So, I am wrecking my brain over China’s decision to issue EUR-denominated bonds (and a few weeks ago USD-denominated ones), in light of its goal of CNY and CGBs internationalization, 40-50bps over the CGB curve (swapped in EUR).

The rationale China is putting forward is that enables it to diversify its investor base on the back of the trade tensions! Seriously? Do they really mean that or are they getting a really bad advice? Wasn’t the intention to actually go the other way as a result of the trade war? Didn’t China want to be become more self-reliant? In any case, China does not need foreign currency funding given its large, positive NIIP. China has the opposite problem. It has too much idle domestic savings and not enough domestic financial assets. This, among other things, creates a huge incentive for capital flight which, despite its closed capital account, China is desperately trying to prevent.

In that sense, China does need foreign investor but to invest in CGBs (and other local, CNY-denominated bonds) to act as a buffer to the potential domestic capital outflow as the capital accounts gates slowly open up. It is for this reason that BBGAI and JPM have started including CGBs into their indices this year.

It is for this reason SAFE decided to scrap the quota restrictions on both QFII and RQFII in September. It is for this reason that Euroclear signed a memorandum of understanding with the China Central Depository & Clearing to provide cross-border services to further support the evolution of CIBM. That opens up the path for Chinese bonds to be used as collateral in international markets (eventually to become euro-clearable), even as part of banks’ HQLA.

All these efforts are done to make access to the local fixed income market easier for foreign investors. And now, what does China do after? Ahh, you don’t need to go through all this, here is a China government bond in EUR, 50bps cheaper (than if you go through the hassle of opening a Bond Connect account and hedging your CNY back in EUR).

This not only goes against China’s own goals regarding financial market liberalization but also against the recent trend of other (EM) markets preferring to issue in domestic currency than in hard currency. And while other EMs may not have had the choice to issue in hard currency from time to time, China does. And while the investor base for other EMs between the domestic and the hard currency market is indeed different, and the markets are very distinctive, China does not have much of an international investor base. Issuing in the hard currency market may indeed ‘crowd out’ the domestic market. Especially when you come offering gifts of 50bps in a negative interest rate environment.

The best portfolio diversifier (cont.)

01 Friday Nov 2019

Posted by beyondoverton in Asset Allocation, China, Debt, EM

≈ Leave a comment

…is (actually) Chinese bonds

When speaking to investors, the two most common questions I get asked, given rather extreme levels and valuations of (most) asset classes, are:

1.Should my asset allocation change dramatically going forward? and

2.What is the best risk diversifier for my portfolio?

I have previously opined on this here. Very broadly speaking, on the equity portion, one should reduce exposure to US equities and increase allocation to EM equities (unhedged). On the fixed income side, one should move completely out of the long end of UST and put everything into T-Bills to 2yr UST; exposure to EU-denominated sovereigns should also be reduced to zero at the expense of EM local (unhedged) and hard currency bonds. In the normally ‘Others’ section of the portfolio, one should include soft commodities (or alternatively, scale everything down to make space for them). Finally, in terms of FX exposure, apart from EM currencies through the unhedged portions of the bonds and equities allocations, one should hedge the USD exposure with EUR.

Here I am adding some more general thoughts on what I consider to be the best portfolio diversifier for the next 5 years, possibly even longer. To my knowledge, ‘noone’ is invested in any meaningful way in Chinese bonds (I am excluding the special situations credit funds, some of which I know to be very active in the Chinese credit space – but even they are not looking at Chinese government or bank policy bonds).

The big fixed income funds, the pension/mutual funds, the insurance companies have zero allocation to Chinese bonds. Some of the index followers started dipping their foot in the space but most of them are either ignoring China’s weight or are massively underweight the respective index. Finally, a sign of how unloved this market is, on the passive/ETF side, the biggest fund is just a bit more than $100mm.

Let me just say here that we are talking about the third (possibly even the second, by the end of this year) largest fixed income market in the world. And no one is in it?

Chinese bonds merit a rather significant place in investors’ portfolios. They offer diversification thanks to their low correlation and superior volatility-adjusted return relative to other developed and emerging markets. In addition, Chinese bonds are likely to benefit significantly from both the passive and active flows going forward: I expect up $3 trillion of foreign inflows over the next decade on the back of indexation.

Bloomberg Barclays Global Aggregate Index (BBGAI) and JP Morgan Global Diversified have already confirmed Chinese bonds inclusion in their respective indices. FTSE Russell WGBI is likely to do that next March. This inclusion is a big deal! It will have huge repercussions on the global bond industry. It is a much more important and far-reaching development than a similar inclusion of Chinese equities in global indices last year. And the market is not only not ready for this, but it is also underestimating its impact overall.

China is a highly rated sovereign with a much better risk/return profile than other high-quality alternatives.  Chinese bonds offer a significant scope for portfolio diversification because they have very low correlation to global interest rates which means lower return volatility.

Therefore, China sovereign bonds offer a much better volatility-adjusted return than Global Bonds, EM Hard Currency and Corporate Bonds, US HY and Equities, Global Equities and Real Estate.

Among the plethora of negatively yielding sovereign bonds, China sovereigns offer a good pick-up over other DM bonds while yielding not too much lower than EM bonds. In addition, they offer much more opportunity for alpha generation than both DM or EM sovereign bonds. This alpha partially comes from the fact that Chinese fixed income market is still not so well developed and partially from the fact that there are not many sophisticated foreign players in it, as access to it is still not that straightforward.

However, things are rapidly improving on the access side. Bond Connect has already started to revolutionize the onshore market. Before the setting-up of CIBM, and especially Bond Connect in 2017, access to the China bond market was extremely cumbersome through a lengthy process requiring approvals from high authority (QFII and RQFII). Bond Connect, on the other hand, does not require domestic account and custody while following international trading practices. In addition, not long ago, it started real-time settlement and block trading. As a result, Bond Connect volumes doubled.

Moreover, in September this year, SAFE decided to scrap the quota restrictions on both QFII and RQFII, while Euroclear signed a memorandum of understanding with the China Central Depository & Clearing to provide cross-border services to further support the evolution of CIBM. That opens up the path for Chinese bonds to be used as collateral in international markets (eventually to become euro-clearable), even as part of banks’ HQLA. Such developments are bound to make access to the Chinese bond market much easier for overseas investors.

September proved to be a very important month for the China bond market also because the authorities finally delivered on the interest rate reform agenda. The central bank eliminated the benchmark policy loan and deposit rates in favor of a more flexible reference rate. This should be positive for yield curve formation and the continued expansion of interbank liquidity.

China does not have some of the weaknesses typical of emerging markets. On the opposite, it has very little sovereign FX debt, has large FX reserves, and it is a net creditor to the world. Moreover, some of the foreign debt is most likely offset by foreign assets.

Corporate-sector leverage, however, is still high, though default rates, despite lots of recent media focus, are still relatively low. On the other hand, the recovery rates are high, while the official, banking and household sectors are in relatively strong position which, reflects degrees of freedom to deal with these challenges. China has large amounts of debt with implicit state backing and a culture averse to defaults. In effect, the government controls both the asset and the liability side of the domestic debt issue thus a debt crisis is much less likely than in a fully free-market economy. The fact that China has the ‘fiscal’ space to deal with the private debt issue is one big advantage it has over DM countries with similarly high private debt burdens but which have also already used the option of shifting that debt to the government balance sheet.

The high debt issue and the authorities’ attitude to it, the structure of the economy (export-driven) as well as the potential transition from an extremely high growth rate to a more ‘normal’ one, makes China’s situation very similar to Japan’s in the late 1980s. Yet, there are also major differences. China’s urbanization rate is much below Japan’s before the 1990 crisis, the real estate bubble is only in the top tier cities as opposed to country-wide as in Japan, the Renminbi is more likely to depreciate going forward than massively appreciate which is what happened to the Yen after the Plaza accord.  

The high debt issue is a problem China shares not only with Japan but also with most advanced countries in the world. Similar to them, China is fully sovereign (the government has full control of the overall economy balance sheet; the currency peg is a “question mark”, not a real issue given China’s large positive NIIP). Of all these advanced economies with similarly high non-financial debt to GDP, only China has not reached the zero-bound*. It is, therefore, likely for the Chinese policy rate to continue to move lower until it eventually hits 0%.

Similar to Japan, it has a high household savings rate and a rapidly ageing population. Yet, Chinese households have relatively low exposure to financial assets and especially to bonds. Given the policy agenda of financial market reform and the life-cycle savings behavior (i.e. risk-aversion increases with age), Chinese households’ allocation to bonds is bound to increase manifold. Moreover, with the looming of the property tax law (sometime next year), I expect the flow into bonds to start fairly soon.

This flow aspect makes the case for investing into China bonds much stronger. Given the size of the Chinese fixed income market, its rapid growth rate and the reforms undertaken most recently, global bond indices had ignored Chinese bonds for too long. However, last year BBGAI announced that it would include China in its index as of April 1, 2019. Purely as a result of this, China bond inflow is expected to reach $500Bn by 2021 as the weights gradually increase from 0.6% to 6%. By then China will be the 4th largest component in the index (after US, Japan and France – and bigger than Germany!)

Before BBGAI’s inclusion, there had never been a bond market that large, that was not included in an index, as the Chinese bond market. In fact, China already represents the third largest bond market in the world, growing from $1.6 trillion in 2008 to over $11 trillion now.

And there is much more money flowing into Chinese bonds, for example, than into Chinese equities for the first time in history.

Despite the setback of FTSE Russell postponing its decision to include Chinese bonds into its index to March next year, JP Morgan did follow through with the inclusion. The FTSE Russell decision to wait for the inclusion happened literally a day before Trump announced that he is considering banning all investments into China on the back of the escalating trade war. Tensions since then have been substantially reduced and I do not expect Trump’s warning to materialize regardless. I expect foreign flows into Chinese bonds, therefore, to continue to grow substantially (probably by another $150Bn combined on the back of the FTSE/JP Morgan inclusions).

And that’s just from index accounts. I expect substantial inflows also from accounts outside of the passive investment universe. In addition, CBs and SWFs (which so far have been the largest investors in Chinese bonds) are also likely to keep increasing allocations. Bottom line is, as the liquidity and transparency improve, unconstrained bond managers and sovereigns are also likely to start allocating money in this space.

And even after these inflows, China bonds are still likely to remain relatively under-owned by foreigners as they would represent just 5% of China’s total bond market (currently foreign ownership of the overall bond market is around 3%, PBOC expects it to reach 15%). Foreign ownership of China sovereign bonds (CGBs) is slightly higher, but even at around 6%, it is materially lower than in other major sovereign bond markets. This under-ownership is even more pronounced relative to the emerging market (EM) universe (the ranges there are between 10% and 50%).

Compare this potential foreign involvement in Chinese bonds with those in Japanese bonds (the second largest market currently in the world, one which, actually, China is likely to surpass very soon): 40% of the traded volumes there are by foreign entities. Foreigners own about 13% of the market there – this may indeed seem small but it is still larger than local banks ownership, plus one has to take into consideration that Bank of Japan owns majority of the issues. The Chinese bond market, on the other hand, is completely dominated by domestic institutions (more than two-thirds is owned by commercial banks).

Domestic commercial banks have very much a ‘buy-and-hold’ mentality but liquidity in Chinese bonds is expected to increase substantially as local insurance companies and asset managers start becoming more active. In the sovereign bond market, for example, there are 45 primary dealers. Auctions are regular with single issue sizes varying between $3bn and $17Bn and maturity up to 50 years. On-the-run bonds (there isn’t a well-defined yield curve which actually provides opportunity for surplus alpha – see above) have bid-offer spreads normally around 1-3bps. In terms of liquidity, bonds stay ‘on-the-run’ for at least a year, in some cases longer.

Finally, foreign investors are expected to continue to get very favorable treatment from the Chinese authorities. The government has an incentive to make things easier as they need the foreign inflows to balance the potential domestic outflows once the current account is liberalized. For example, the tax changes implemented last year allowed foreigners to waive the withholding tax and VAT on bond interest income for a period of three years.

I am still frankly shocked how little time investors have to discuss these developments above but, at the same time, how eager they are to discuss the Chinese economy and the trade tensions. From one hand, they acknowledge the importance of China for their investment portfolio, but on the other, they continue to ignore the elephant in the room being the Chinese bond market. I understand that this choice is perhaps driven by investors’ inherent negative bias towards any Chinese asset, but the situation between asset and asset is much more nuanced.

In the fixed income space, one can be bearish select corporate credit and bullish CGBs or bank policy bonds (in fact, the more bearish one is on corporate credit, the more bullish sovereign bonds one should be). Finally, I do acknowledge that the big unknown here is the currency. But even there, the market has become much more sophisticated: one can now use a much longer CNY/CNH forward curve to hedge.

Bottom line is that if you are still looking for a fixed income alternative to diversify your portfolio and you are not looking at Chinese sovereign bonds as an alternative, you are not being fiduciary responsible.

*For more details, see JP Morgan’s economics research note, “China’s debt: How will it evolve?”

The best portfolio diversifier

24 Thursday Oct 2019

Posted by beyondoverton in Asset Allocation, EM

≈ 2 Comments

Given low, and in some countries negative sovereign rates, are sovereign bonds still the best portfolio diversifier in the long run? 

Yes

Because the portfolio optimization function has also changed. We are moving away from a world of profit maximization to a world of loss minimization.

Given persistent and large output gaps and surplus capital in the developed world, the expected return on future capital investment should be negative.

If Japan, Switzerland, Sweden and Denmark are any guide, their respective stock markets are down or flat since rates hit 0%. US is still a massive outlier (buybacks) but that is also fading (SPX buyback index is down YTD).

From a long-term point of view, I would still own sovereign debt as it has superior risk-adjusted returns even at these low yields. For example, in the last bear market for bonds, 10yr UST went from 1.95% in 1941 to 14.6% in 1982. Annual real total return for the period was 0.4% (annual nominal return was 5% with Sharpe ratio of 0.54). There were 10 years of negative returns (24% of the time) with the largest drawdown of 5% in 1969. In the bull market that followed, annual real returns were much higher but that was only because of disinflation (nominal returns were only marginally higher – around 6%). We still had 6 years of negative returns, but the largest drawdown was 11%.

‘Bond bubble’ is an oxymoron. The best value on the curve now: T-Bills. If you could be bothered to roll them, they would have a similar return to the long end but much lower volatility. The Fed just announced it is in the market buying T-Bills (as it ‘should’: the Fed is massively underweight T-Bills vs both history and the market). Despite heavy Treasury issuance net supply of T-Bills is expected to be negative next year.

US retail is massively underweight USTs: about 3-5% of all financial assets and about 2% of their overall assets.

Is gold a better portfolio diversifier when sovereigns yields are negative? Perhaps, in the short term and only for retail. Long-term, expected return on gold should also be negative (as long as sovereign yields are negative). For institutional investor gold is an inferior option from a liquidity and regulations point of view.

Is there a better portfolio diversifier at the moment, short-term? Perhaps soft commodities which trade below production costs (for some, like cotton, wheat – substantially below) – compare to precious metals which trade 50% above marginal cost of production. 

Soft commodities might be the exception among the major asset classes, whereby expected return is actually positive in a negative sovereign yield world, given that they already experienced negative returns in the past 10 years and their zero (negative?) weights in institutional or retail portfolios (mean reversion).

One can go even fancier here, up the risk curve, and allocate to hard currency emerging market debt, which has had even better risk-adjusted returns than USTs over the last 3 years. And, depending on currency views, go even further into local currency (unhedged) emerging market debt. USTs do not need to be negative, just to hover around 0%, for emerging market debt to really outperform, assuming no major market dislocation.

Finally, on the equity side, some allocation to emerging markets equity is also probably warranted given their massive under-performance specifically to US equities and my projected negative returns of the latter going forward. Unlike their developed market counterparts, emerging markets are not running negative output gaps and therefore, capital is still expected to earn a premium there.

Bottom line: if we are indeed in a loss-minimization type of world when it comes to investment returns (note, this does not assume any kind of market crash) one is still better off staying in sovereign debt, even when it yields negative as every other liquid asset is bound to return even more negative on any reasonable time scenario.

The 60/40 portfolio is a myth

24 Thursday Oct 2019

Posted by beyondoverton in Asset Allocation

≈ Leave a comment

Tags

Debt, Equity

-US households balance sheet is comprised roughly of 70% financial assets and 30% real assets. That mixture has actually been relatively stable throughout the post WW2 period.

-The non financial side of the balance sheet is comprised of 80% real estate and 20% ‘goods’ (car, furniture, etc.). Since WW2 there has been a gradual increase in the real estate portion from 70% of total to about 85% in 2007.

-The biggest item on the financial side of the portfolio is the pension fund (PF) allocation at around 30% of total. This was not always the case. In fact, it has gradually grown from 9% in 1945.

-The second biggest allocation is to equities (EQ) direct at around 18%, which turns out to be the average for the whole period post WW2. The highest allocation was in 1999 and 1965 at 28%, the lowest in 1984 at 10%.  Households own equities also indirect through their pension and mutual funds.

-The third biggest allocation is cash at 15%, 17% being the average in the post WW2 period, 25% the highest in 1984, and 12% the smallest in 1999.

-The fourth largest allocation is to mutual funds (MF) at 9%. Just like with PF, this allocation has increased gradually from pretty much 0% before the financial liberalization of the early 1980s.

-Fixed Income (FI) direct only comes fifth here at 6%, average 7%, highest 11% in 2008, smallest 5% in 1972. Households also own fixed income indirectly through their pension funds.

-The FI portfolio is comprised of USTs, agencies, munis and corporate debt. Munis have the largest allocation at around 39% followed by USTs at 33% corporates at 19% and agencies.

-the FI portfolio looked very different in the early days with the bulk of the exposure in USTs (84%), corporates (11%) and munis (5%). Agencies exposure kicked in only in the late 1960s.

-US households also own their own businesses (non-corporate equity – NCEQ) which used to be their largest exposure immediately in the early days post WW2 at 31% but has gradually halved by now.

-If we add cash and loans (very small exposure) to FI, the FI allocation overall goes to 23%. If we add the MF exposure to the Equities exposure, the latter goes to 27%. Life insurance (LI) and ‘Other’ comprise the remaining 5%.

-If we extract the PF exposure to its respective allocation to the different asset classes, the overall ‘concise’ US household portfolio has these weights at the moment: FI-30%, EQ-40%, NCEQ – 15%, LI/Other – 15%.

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