By Anna Hirtenstein 

Investors seeking shelter from the turbulence in markets have found a new haven: Chinese sovereign bonds.

Foreign capital flowed into locally denominated Chinese government bonds in the second quarter at the fastest pace since late 2018, according to data from CEIC, an economic data provider. It surpassed 4.3 trillion yuan ($619 billion), the highest on record.

International ownership of China's debt has been on the rise in recent years as Beijing has made it easier to buy and sell and after the securities were added to key bond indexes beginning in 2019. Passive bond funds try to match the composition of those indexes. And active investors have found the relatively higher yield and stability of the Chinese bond market attractive.

"They're really the one asset out there that's both defensive and that's offering you some yield," said Evan Brown, head of multiasset strategy at UBS Asset Management. "If things go wrong -- if global growth disappoints or there's an increase in trade tensions or a flare-up in coronavirus, Chinese sovereign bonds will react with bond yields coming down."

That was proved out this year through the coronavirus market panic. China was the center of the first outbreak and its lockdowns began months before Europe's and the U.S.'s The local bond market rallied at the height of the turmoil, although it has pulled back recently as the economy has slowly gotten back on its feet.

In April, benchmark 10-year Chinese sovereign bond yields reached the lowest point in over a decade, declining over half a percentage point compared with the start of the year, according to data from Refinitiv. Because bond prices rise as yields fall, this proved a windfall for investors at a time when stocks and riskier bond markets were sinking.

Even so, Chinese yields are also significantly higher than for government debt issued by the rest of the world's largest economies, with its benchmark 10-year bond currently yielding 3.118%. That compares to 0.597% in the U.S., 0.023% in Japan and minus 0.515% in Germany.

Switzerland-based private banking group Lombard Odier recently increased its holdings of Chinese government bonds. China was previously part of its emerging-market allocation, but from July the asset manager created a separate category for China's debt. It now makes up between 2% and 3% of several multibillion-dollar portfolios, about the same percentage allocated to high-yield debt or real estate.

"I'm not so sure that characterizing it as an emerging market is the correct thing to do anymore," said Stephanie Monier, chief investment officer at Lombard Odier. "We see China as a safe haven for government bond issues."

Other emerging-economy bond markets, such as India and Russia, sold off in the coronavirus market panic. Those economies are more reliant on foreign inflows to support their financial systems.

Investors are betting that the People's Bank of China will continue to stimulate the world's second-largest economy to help it recover from the coronavirus-induced downturn. Unlike the Federal Reserve and the European Central Bank, it has held back from large-scale action to date and can do more going forward, according to Qu Hongbin, chief economist for China at HSBC Holdings.

"They're still taking a gradual and targeted easing approach rather than a whatever-it-takes approach," he said. "They're saving some ammunition to use in the future."

He expects the PBOC to cut interest rates further in the second half of the year and pump more liquidity into the economy, particularly to small- and medium-size businesses. China's benchmark lending rate, known as the one-year loan prime rate, is currently at 3.850%. This gives the central bank more room for reductions than in other large economies.

To be sure, there are risks investing in Chinese bonds, which for years were inaccessible to foreign investors because of strict capital controls that were only partially loosened in recent years.

Long-running tensions with the U.S. and the implementation of the new security law in Hong Kong have ignited concerns about the potential for additional tit-for-tat policy and resulting market volatility. While inflation has been subdued in China in recent years, it has a history of price rises running out of control, which could limit the ability of the central bank to cut rates.

European investors, who are weighed down by negative interest rates at home, have become particularly active in the market.

Trading of locally denominated Chinese government debt in Europe's secondary market rose sharply in the second quarter, according to bond trading platform MarketAxess. While volumes are still relatively modest, over $914 million of bonds changed hands in the second quarter, up from $81 million in the previous one.

"We think Chinese bonds are very attractive," said Jason Daw, head of Asia-Pacific research at Société Générale SA. "They won't necessarily do it on a daily basis, but they provide protection if you get a big risk-off event or dislocation."

--Pat Minczeski contributed to this article.

Write to Anna Hirtenstein at anna.hirtenstein@wsj.com

(END) Dow Jones Newswires

July 13, 2020 05:44 ET (09:44 GMT)

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