Renminbi Bond Fund -
Ten Years On
Launched almost 10 years ago, taking renminbi exposure through the Renminbi Bond Fund remains one of Stratton Street’s most compelling investment themes. Over the past decade returns have been extremely strong with an annualised return of 9.1%, net of fees in US dollar terms, which spans the financial crisis in 2008 when the fund returned +5.6%.
Renminbi Bond Composite performance chart (gross)
Why do we think the fund is so compelling?
It is compelling from a NFA perspective. We define net foreign assets (NFA) as:
Net Foreign Assets (NFA) = Cumulative Current Account (CA) + Valuation effects (VE)
This methodology captures the build-up of assets or liabilities not just of the government, but also the debt or asset accumulation of corporates, banks and individuals. Consequently, the concept of net foreign assets measures the aggregate savings or borrowings of the entire country, not just government debt. Countries that save more than they invest run current surpluses and vice versa.
Andy Seaman, in his paper ‘Does Lending to debtors make sense for bond investors?’ (2013), demonstrated the importance of NFA analysis as a long-term driver of currency and bond returns. His theoretical framework suggests that the performance of bonds and currencies of debtors and creditors varies according to whether the world is experiencing a period of reflationary financial market conditions, where capital flows from creditors to debtors, or whether we are in deleveraging phase with capital flowing in the opposite direction. As capital flows from the creditor countries this should be associated with a depreciation of their exchange rates with a corresponding rise in the exchange rates of the debtors.
Stratton Street’s view is we are in a deflationary period of the cycle as central banks start to remove policy accommodation and QE is scaled back. Thus, from a portfolio positioning point of view this favours creditor nations: China is a creditor nation and we retain a positive view of the renminbi.
The chart below shows how currency shifts support NFA analysis:
The chart above shows the spot return versus the dollar with each country’s NFA position. The fact that the top four performing currencies are all creditors lends weight to the argument that NFA is an important long term driver of currencies. It is also no surprise to us either that the renminbi tops the table in terms of performance being a creditor nation and this is even without factoring in the positive carry. We continue to expect China to run a persistent, albeit smaller (2-3% of GDP) current account surplus and expect this trend to continue and its domestic goal of boosting consumption is best achieved with a stronger exchange rate.
Other factors influencing currencies include growth, inflation and interest rates: these all look supportive from a renminbi perspective. Plus, on an income adjusted purchasing power parity basis the renminbi is 10% undervalued (Big Mac data).
Opportune timing: renminbi should strengthen as dollar peaks
China has managed its currency against a basket of trade weighted partners since the currency was unpegged in 2005. The basket comprises of 22.4% US dollars, 16.3% EUR, 11.5% JPY, 10.8% KRW with the balance in a range of currencies. The renminbi fluctuates in a band, currently 2%, around the basket.
CFETS RMB Index Weighting
Positive carry enhances currency returns
The portfolio is currently 100% exposed to the renminbi through the foreign exchange market using either the Chinese onshore currency known as CNY or the offshore currency CNH. Currently we are 100% exposed through CNH but the mix can vary. Going forward, it may also vary if we bought CNY bonds directly as bond-connect has made the process much simpler and provides access to some liquid names. Chinese rates are higher than US rates so we are paid to buy and own the renminbi forward – the amount fluctuates with interest rate movements. For the year to the end of September 2017 the carry has added 3.47% to the spot return of 4.95% for a total return of 8.42% against the US dollar.
Overseas investors are underweight China
International investors hold less than 2% of the Chinese bond market, which is far too low given the importance of the Chinese economy and the scale of the bond market. The Chinese bond market at USD 10tn is the third largest global bond market after the US and Japan. The launch of “Bond Connect” in Hong Kong is likely to increase the likelihood of inclusion in the major bond indices. This will lead to significant inflows from passive fixed income investors.
Returns maximised through selecting undervalued Eurobonds
Using our proprietary NFA screen and relative valuation model (RVM) we select Asian bonds that trade several credit notches cheap versus our models offering additional upside were they to trade at fair value. At the moment the portfolio (based on the AIF as of 30 September 2017) is trading around 4 notches ‘cheap’ with a gross redemption yield of 4.1% and a weighted rating of A. We continue to favour positioning at the long end on a duration weighted basis as we expect the Fed to remain ‘ahead of the curve’. By hedging into renminbi we gain the same currency exposure as a pure renminbi investment but with a significantly higher yield, broader investment opportunities and greater liquidity. Currently the average issue size stands at over USD 1 billion.
Significant outperformance against the peer group
Since the launch of many newer renminbi bond funds in mid-2011, Stratton Street’s Renminbi Bond Fund has outperformed significantly.