Deep Dive: Endowus China Fixed Income Portfolio

What is the Endowus China Fixed Income Portfolio?

The Endowus China Fixed Income Portfolio provides investors with attractive long-term yield and greater diversification through a fixed income approach to investing in the onshore and offshore China bond markets with higher yield  compared to the rest of the global fixed income market.

The portfolio is designed to give exposure to bond instruments issued by companies, government, and agencies in both the onshore and offshore markets:

• Onshore bonds: Securities listed on the mainland China exchanges, priced in Chinese yuan (CNY); and
• Offshore bonds: Securities listed outside China, and traded in more liquid currencies such as USD.

The portfolio will primarily allocate to securities issued by Chinese entities, or companies with a high business dependency to China, and therefore provides a way for investors to express a view on the Chinese economy with a fixed income exposure.

The diversified onshore and offshore exposure from the portfolio allows for a broader and diverse source of investment opportunities. The underlying fund’s active managers take into consideration the overall macro environment and the bottom-up evaluation for each sub segment of the market, as well as the fundamentals of the issuers to take advantage of the best available opportunity at any given time. On average, the portfolio has historically provided an exposure of about 60% to onshore bonds, and 40% to offshore bonds.

In terms of the portfolio’s sector allocation, it is slightly skewed towards corporate credit, but the portfolio nevertheless maintains a healthy exposure to sovereign and agency debt. Investors may wish to note again that the final portfolio allocation is based on the prevailing opportunities, and the portfolio is effectively an unconstrained strategy within the predefined universe of Chinese bonds.

Learn more about how you should approach a core-satellite portfolio investment strategy here.

What are the underlying funds in the portfolio?

We have selected two best-in-class funds focused on investing in Chinese fixed income, managed by experts in Chinese fixed income markets, BlackRock and Neuberger Berman.

These two funds are able to cover the broad spectrum of the Chinese fixed income market, with Blackrock providing both onshore and offshore investment opportunities with an active and tactical allocation between the two opportunities, while the Neuberger Berman fund is primarily an onshore-focused fund with some smaller exposure to offshore opportunistically.

Collectively, the funds provide investors an optimised exposure to investing in both Chinese bond markets.

Why invest in China fixed income?

Chinese bonds provide attractive long-term opportunities, despite recent headwinds

The historical growth of the Chinese bond market has been explosive, in line with the unprecedented transformation of the Chinese economy in establishing itself as the second largest economy globally today. However, the recent slew of bad news on the tightening of regulations on the Chinese real estate sector has dampened the market, prompting some investors to question whether it is still safe to invest in Chinese bonds. There are also longer-term structural concerns related to the over-indebtedness of certain sectors and the overall economy.

Despite these concerns, it is important to understand that the Chinese fixed income market is becoming broader and deeper.

The Chinese bond market is the second largest in the world, with a highly diversified basket of corporate and government issuers which can be further drilled down into their respective sectors. Among this, the real estate sector only constitutes about 2.5% of the total market, and any such single-sector instability is unlikely to have a detrimental effect on the overall capital markets ecosystem. While there indeed had been contagion across other Chinese bond issuers, this is largely driven by short term trading or some irrational actors in the market.

Additionally, given that the regulatory risks are revealing the weaker names in the market and pressuring them to be more transparent and responsible about their use of leverage, the Chinese bond market may become more mature, transparent and efficient driven by the market.

Given this, the concerns about regulatory risks, while real, may in the long term be proven to be growing pains as the Chinese market achieves greater sophistication, which will in turn offer greater upside and opportunities in the long term.

Chinese fixed income provides greater diversification to your portfolio

Chinese fixed income, as an asset class, is unique in the way that it provides diversification in three different aspects:

• Against global bonds;
• Against global equities, including Chinese equities; and
• Within the China bond market itself, between onshore and offshore securities.

The key reason behind this attractive characteristic is that the Chinese economy, as a whole, has a relatively high degree of non-correlation compared to the rest of the world — for example, Chinese bonds are heavily guided by the interest rate directions set by the Chinese government and its central bank, which are often independent of the policies adopted by the US and other Western monetary authorities. Similarly, as onshore and offshore bonds are typically denominated in CNY and USD respectively, they have differing degrees of sensitivity to macroeconomic conditions in China, US, and the rest of the world.

Another reason is that foreign participation in the Chinese bond market is still in its infancy, as the onshore bond market, in particular, was only technically opened up to non-Chinese investors in 2017 via the Bond Connect programme. Nevertheless, foreign ownership of Chinese Onshore bonds only remains at approximately 2.5% today, making the market less correlated to the rest of the world.

Given this, adding a China fixed income allocation to your investment portfolio is highly likely to be effective in optimising your overall expected returns and risks, almost regardless of what other asset classes are held in your basket.

Chinese fixed income generates higher yields

With generally higher interest rates in the domestic markets versus global fixed income markets and in order to attract greater participation in the market, issuers in the Chinese fixed income market, both corporates and government alike, have typically been offering an attractive level of yield compared to their global counterparts of similar attributes.

This has rather successfully captured investor appetite, especially given the super-low interest rate environment globally today with some developed country sovereigns paying negative yields. As a result, many investors and market participants today utilise Chinese bonds as a source of yield pick-up for their portfolios.

Who should invest in China fixed income?

While Chinese bonds offer highly attractive opportunities as outlined above, the market is not without its risks, as it is a large economy with intricate ties to the rest of the world. Investors may find some confidence in the fact that the Chinese bond market actually exhibits a relatively low volatility, with the Bloomberg China Aggregate having a standard deviation of 4.5% between January 2013 and October 2021.

However, the market was not spared from multiple drawdown events historically, and it is important for investors to consider their risk appetite carefully before deciding to allocate specifically into China.

Ultimately, the longer one’s investment horizon, the greater the chance of their investment riding out the market volatility to achieve a higher return. Investors who are prepared to withstand the potentially steep losses arising from market volatility and have a mid-to-long term investment horizon would be best suited to allocate to Chinese fixed income.

Why should you invest in the Endowus China Fixed Income Portfolio?

Defensive solution to participate in China's growth story

While there is much spotlight on the explosive historical growth of China, as well as its rosy future outlook, participating in the Chinese market can come with significant risks which rightfully can be daunting and unsuitable for some investors especially in the Chinese equity markets.

The Chinese fixed income market, on the other hand, is a more stable way to gain exposure with the stronger yield pick up and the long term growth opportunities of the fixed income market.

The portfolio was constructed to give a diverse exposure to high-quality Chinese corporates from all sectors, as well as to the government and their agencies (e.g. municipalities, state-owned enterprises), so that it captures the appeal of the Chinese economy while preserving the more defensive characteristics of the fixed income asset class.

Active management by top fund managers to generate higher returns with lower risk

Given the vast investment universe for Chinese bonds, as well as the complexity in obtaining local, ground-level knowledge that directly influences the assessments on issuers and securities, we believe that investing in Chinese bonds can be most efficiently done by leveraging the expertise of leading fund managers in the China fixed income space to extract alpha through their proven investment approaches.

This is also especially true because the Chinese bond markets remain less efficient with low foreign participation, and active managers can  exploit yield differentials by arbitraging across the onshore and offshore markets.

The portfolio has been constructed to benefit from the collective wisdom of the underlying funds to generate the best risk-adjusted returns through exposure to a diverse basket of Chinese fixed income securities, and this has proven to be  successful historically compared to different China fixed income indices:

Ongoing assessment of underlying funds by the Endowus Investment Office

The underlying funds in the Portfolio have been selected based on the rigorous assessment by the Endowus Investment Office for their superior quantitative and qualitative characteristics, and are believed to be the best-in-class among their peers.

However, with that being said, as the Chinese fixed income market continues to evolve and garner higher popularity among investors worldwide, we are also constantly keeping an eye on the space, and this is especially relevant for this asset class as the choice of funds available to retail local investors is rather constrained today.

To make sure that the portfolio reflects the best opportunities in Chinese fixed income investing, we conduct ongoing re-assessments of the funds to ensure that their superior characteristics are maintained into the future, and where needed, to introduce new funds to supplement or replace the existing portfolio design.

Read more: Deep Dive: Endowus China Equities Portfolio

Appendix: Portfolio details

Portfolio allocation and cost

Historical risk and return

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