(Bloomberg) -- Overseas funds returned to selling China’s bonds in January after a one-month pause, underscoring the relatively unattractive yields on yuan-denominated debt as Beijing keeps monetary policy loose to support growth. 

Foreign holdings of Chinese onshore bonds in the interbank market including sovereigns, policy bank debt and other fixed-income securities slid by 106.5 billion yuan ($15.5 billion) to 3.28 trillion yuan, the lowest since 2020, according to Bloomberg calculations based on data from the China Central Depository & Clearing Co. and Shanghai Clearing House. That’s also the biggest outflow since May.

The figures had been highly anticipated since December’s data showed overseas investors added to holdings of China’s bonds after record outflows through most of last year. Global funds are looking to see how the nation’s debt and the yuan react to the country’s reopening from Covid Zero and the outlook for monetary policy as the central bank seeks to bolster the recovery.

There are a number of positives for Chinese bonds this year including an improving economy that may boost sentiment toward the nation’s assets, while they may benefit from passive flows amid a recovery in global debt due to being an index component. Among the negatives, they may be at the risk of asset reallocation as investors seek higher-yielding assets, while the policy divergence between China and the US damps demand for the Asian country’s securities.

Index tracking and reserve-allocation inflows into China bonds should resume this year, but active investment flows are unlikely to return until China bonds’ negative yield gap to Treasuries turns positive, or the yuan strengthens, said Linan Liu, head of Greater China macro strategy at Deutsche Bank AG in Hong Kong. Outflows are likely to persist until overseas demand picks up in the second half, which should help boost the annual inflow to 250 billion yuan, she said.

Yield Divergence

China’s 10-year bonds yield 2.92%, compared with 3.82% for similar-maturity US Treasuries. That yield discount was one factor spurring foreign investors to cut their holdings of the nation’s sovereign bonds by 66.3 billion yuan last month. 

Abrdn is positive on China’s five-year bonds but short 30-year debt based on expectations the economic reopening will be accompanied by an accommodative monetary and fiscal stance, said James Athey, investment director of rates management at the money manager in London.

Chinese bonds may continue to be a beacon of stability in 2023 without currency hedges, but “as we are expecting recession and ultimately rate cuts in the rest of the world, we see higher-yielding and more attractive duration opportunities in the likes of the USA and Mexico,” he said. 

The cost for dollar-based investors to hedge yuan bond holdings has been negative since May. Taking this hedging into account, yields on Chinese government debt are higher than those of comparable Treasuries, but that has done little to reverse the outflows.

‘Start to Nibble’

Some investors are waiting for a better entry point to buy the nation’s bonds, and this may come about if yields rise as the reopening leads to quicker economic growth and inflation.

If the 10-year yield climbs to around 3%, “we probably start to nibble back around those levels again” to take advantage of the volatility, said Brad Gibson, head of Asia Pacific fixed income at AllianceBernstein in Melbourne.

The resumption of foreign outflows in January reduced the share in China’s onshore sovereign notes owned by overseas investors to 8.8%, from as high as 11.1% a year ago. Similarly, the proportion of interbank bonds held by global funds dropped to 2.6%. 

‘Strong Diversification’

While that may disappoint Chinese officials who have been striving to open up onshore markets to the world, the relatively low foreign ownership means the nation’s bonds may remain less correlated with major global markets.

“The market remains dominated by domestic investors including Chinese banks, pensions and mutual funds,” said Desmond Soon, head of Asia ex-Japan investment management and a fund manager at Western Asset Management Co. in Singapore. The low sensitivity of China government bond yields to global interest rates has demonstrated their “strong diversification attributes within a global government bond portfolio — and we believe that the low correlation will continue,” he said.

--With assistance from Tania Chen.

(Updates to add hedged yield comparison in ninth paragraph)

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