Rates Hit New Low: Time to Revisit Bond Funds?

In recent months, the Chinese bond market has been a focal point for investors, particularly since the implementation of the "September 24" policy, which initially sent a wave of optimism through the market. This "debt bull" market, however, seemed to hit a pause button amid a precarious balance between stock and bond performances, redemption turbulence, and fluctuating expectations regarding growth policies. As the net value of assets oscillated, the sentiment among investors—referred to as "egg gatherers" in this context—has also shown considerable volatility.

Amid speculation about whether the market would turn around, a new bout of favorable conditions has emerged quietly within the debt market. Although the stock market continues to rise, buoying overall sentiment, the bond market now appears to be less burdened.

A significant milestone was reached when the yield on China's 10-year government bonds dipped below 2%, marking the lowest point since April 2002. This decline is particularly striking given the multiple levels of resistance that have been surpassed recently, demonstrating a crucial shift in market dynamics.

Advertisement

With interest rates now at historic lows, the pressing question is: What lies ahead for the bond market? How should investors manage their bond funds? By understanding the underlying trends and policy implications, we can thoughtfully navigate this evolving landscape.

Understanding the Current Bond Market Conditions

The recent downturn in bond yields can largely be attributed to a combination of factors that need clarification and analysis. A key driver is a repricing of the "weak reality" framework that the market currently operates in. While stock markets often trade based on expectations, the bond market reflects more immediate realities. For a fundamental turnaround in bond market trends, we typically need to see consistent recovery in economic data over a quarterly basis, or a shift in monetary policy towards tightening.

Currently, China finds itself in a transitional phase where policy effects are filtering down to the economic level. While monetary easing remains the prevailing approach, sluggish internal demand has complicated the recovery process, suggesting that the economic fundamentals do not yet support a full-scale shift in the bond market.

Another contributing factor is the expectations surrounding the liquidity conditions. Despite the anticipation of an increased supply of local government bonds, what caught many by surprise was the central bank’s aggressive use of various monetary tools to counterbalance any potential upheaval in the market. Recent announcements revealed that the central bank purchased a net 200 billion yuan in government bonds and conducted 800 billion yuan in reverse repurchase operations in November, effectively injecting 1 trillion yuan in medium to long-term liquidity into the market.

This proactive liquidity management has led to an unusually stable performance in the bond market, unlike the fluctuations observed during periods of heightened government bond supply in October and November of the previous year.

Furthermore, another emerging theme is the growing "asset shortage" among quality investments. Since the beginning of the year, the lack of available high-quality assets has been a major contributor to the declining yields in the bond market. Recent regulatory initiatives aimed at lowering interbank deposit rates have led to an increased appetite for bond investments as other assets become less competitive.

Specifically, the recent regulatory push requires that interbank deposit rates, which were previously as high as 1.7% to 1.8%, be brought down to a range of 0% to 1.5%. This adjustment incentivizes investment funds and money market products to move away from interbank deposits in search of higher-yielding assets, therefore increasing allocations toward bonds.

As some assets begin to have their expected yields reconfigured, the logic behind the "asset shortage" becomes increasingly entrenched. Without the reliable high yields from interbank deposits, firms managing retail financial products are likely to reduce their holdings of these deposits and seek out bonds, thus enhancing the overall attractiveness of the bond market.

Looking Ahead: What Does the Future Hold for the Bond Market?

Historically, the end of the year has been favorable for the bond market, according to calendar effects. Research indicates that December typically sees a higher probability of bond yields declining—in fact, over the past ten years, this has occurred nearly 70% of the time. Additionally, investment firms have consistently ramped up their bond purchases during December in recent years.

The underlying drivers of this December trend include a combination of liquidity being bolstered by the central bank's interventions and the gradual emergence of policy clarity as the year comes to a close. Moreover, various investment institutions often gear up to make strategic purchases towards the end of the year in preparation for the upcoming year’s portfolio allocation.

Assessing the current landscape, liquidity appears to be supported by the central bank’s injections and anticipated adjustments in reserve requirements. Concurrently, while concerns about large-scale local government bond issuance loom overhead, the actual pressures may be manageable. If all of the 2 trillion yuan in replacement bond quotas were utilized fully in the months of November and December, the net supply of rate bonds would be approximately 1.5 trillion yuan, which aligns with figures seen in September and May of this year, and is still less taxing than the May-July surge.

Notably, in previous years, bond yields tended to witness upward adjustments in August and September, only to decline again around December. However, this year saw a robust performance in the bonds, with yields exhibiting a downward trajectory following a brief consolidation period from late September to early October.

Despite the expectation of a year-end configuration, uncertainties surrounding the US dollar's strength and ongoing trade tensions with the United States may continue to exert pressure on the renminbi’s exchange rate, impacting anticipated easing measures. Since this current trend initiated in mid-November appears to be driven more by trading institutions, there may be limited room for yields to drop further when institutional buying comes into effect at year-end.

According to insights from various sell-side institutions, in the short term, long-term government bond yields may hover around the critical 2% level, but sustained downward movement may require stronger catalysts to drive that change. Without significant easing measures, we could see rates enter a phase of relative turbulence rather than swiftly transitioning lower.

In a mid-term perspective, the trajectories of the bond market will largely depend on the outcomes of the upcoming central economic meetings and the subsequent Two Sessions for fiscal and monetary policy indications. If there are unexpectedly strong policies aimed at stabilizing growth, short-term long-end yields might face adjustments, although they may not exceed prior peaks seen before September. Conversely, should policies fail to meet expectations, long-end yields may remain strong and stable, reassuring the market of continued monetary easing that could ultimately lead to yields settling below the 2% mark.

Long-Term Investment Strategy in an Evolving Market

Looking forward, despite some short-term volatility, the slow but steady direction of the bond market remains intact. Investors are advised to remain vigilant and carefully navigate this environment, as bond investments continue to demonstrate value.

In fact, over the past decade, typical equity funds have necessitated a volatility rate of around 22.82% for a return of 10.03%, while equity-mixed funds have required a 21.25% volatility for an 8.51% return. In contrast, long-term pure bond funds have delivered a 5.02% return with only 1.02% volatility, and short-term bond funds yielded a 3.62% return with just a 0.44% volatility.

This relationship between risk and return highlights the increasing stability of the bond market compared to the stock market's fluctuations. Consequently, within the broader asset allocation spectrum, fixed-income assets persist as suitable anchor points in portfolios.

Bonds, by their nature, yield income, embodying a distinct "fixed-income" characteristic that insulates them from drastic price drops, provided that they remain clear of default risks. Even during periods of downturns, the interest accrued can mitigate losses to some extent, and a market recovery can significantly enhance total returns.

This trend of "bullish long, bearish short" has been characteristic of the Chinese bond market over time, with the Wind Bond Index for bond funds showcasing resilience in reclaiming upward momentum after periods of volatility. Anticipating the long-term, as China's economy transitions from rapid growth to higher quality development, the demand for stable investments like bonds will only increase.

The current economic transformation is marked by critical factors, including the management of debt and the need for a smooth transition in the real estate sector, alongside nurturing new productive forces. All these require a nurturing monetary environment, as lower interest rates emerge as an inevitable trajectory.

Upon closer examination, considering market investors' needs and the plethora of substantial medium and long-term influences, it's evident that the bond market remains in a relatively favorable position for investors. Strategically planning for bond investments with a long-term hold perspective aligns well with current market realities.