“The key risk for trading local yuan bonds is the currency. It cannot be compensated for by the yield unless you can hedge out the currency risk,” said UBP Asset Management senior macro and FX strategist Koon Chow, who is based in London.
He expects the yuan to fall 5% against the central bank's basket of trading partner currencies to about RMB 7 per dollar (from 6.69 today) in the coming 12 months, “to keep the currency competitive and reflect the capital outflows". In 2015, the currency was down 8% versus the basket.
The weakening of the yuan will be mainly driven by “repayments of external debt [by Chinese companies] and the ongoing process of Chinese corporates looking for investment opportunities globally", he said.
But the pace of depreciation should be less intense than last year because Chow believes the US dollar has already peaked, which is helpful to Chinese policy makers.
By achieving depreciation not only against the US dollar, but all the other trading partners, "the policymakers can allow some depreciation to enjoy the benefits, such as exports, and at the same time the costs of depreciation and risks of capital flight is a lot less."
Impact on bonds
The local currency bond market might get more interesting in the next five-to-ten years, given the RMB should still weaken over the next two years, Chow added. “With the long-term opportunity, why don’t you wait until the depreciation is over before entering and tying up your money?”
JP Morgan Asset Management Asia chief market strategist Tai Hui believes yuan depreciation is coming to an end in the near term, ahead of the G20 meeting in September.
However, “the yuan is still expensive in term of the basket of currencies. Ultimately, the yuan needs to be weakened on a trade-weighted basis,” he noted.
Compared to the currency’s 10-year average on a trade-weighted and inflation-adjusted basis, the yuan is now 1.2% above the long-term average, and the US dollar is 1.7% higher, according to data from Factset and JP Morgan AM.
China’s 10-year treasury bonds currently yield 2.9%, in contrast to negative interest rates of government bonds in some European countries and in Japan. CSOP saw some strong inflows into its treasury bond ETF last month.
Onshore junk bonds, meanwhile, have growing risks amid rising defaults and at the same time yield lower than their offshore counterparts with US dollar-denominated debts.
“A 3% decline in China's currency could wipe out [the overall return], and that keeps investors more cautious,” Hui said.