China auction buys it membership of an elite financial club

During the last decade, the world has had to get used to central banks such as the Bank of Japan, the Swiss National Bank and the European Central Bank imposing negative interest rates.

At the same time, bond investors have had to get their head around issuers like Germany and Switzerland issuing debt with a negative yield – in other words, investors have been paying bond issuers for the right to lend to them.

Even the UK got in on the act when, earlier this year, it issued three-year gilts (UK government IOUs) with a negative yield.

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The phenomenon reflects a variety of factors, including risk aversion on the part of some investors, plus of course quantitative easing (QE), the process by which central banks seek to boost economic activity by increasing the money supply, usually by buying government bonds.

That has served to push up demand for such bonds and, with that, the price.

When the price of a bond goes up, the yield goes down.

Along with that is another, related, weapon that has been deployed by central banks known as “yield curve control”.

This is where a central bank adapts its QE policy to keep the yield on a specific duration of government bond, for example a five-year bond or ten-year bond, at as close to its target as possible.

A good example here is the Bank of Japan which, in 2016, set out to keep the yield on 10-year Japanese government bonds (JGBs) at zero.

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The thinking was that, if it cost next to nothing to borrow money for 10 years at a time, it would encourage more investment over that period.

It is a policy on which the Reserve Bank of Australia has also recently embarked.

Until fairly recently, membership of the elite club of countries that have been able to embark on issuing bonds with a negative yield has been confined to countries with excellent credit ratings, such as Germany, the Netherlands, Switzerland and Japan.

This year, though, not only has the UK joined that club; so too have a range of other countries, such as Italy, Spain and Greece, that were at the centre of the eurozone sovereign debt crisis of 2011-12.

And, today, the club admitted possibly its most eyebrow-raising member yet: China.

The Chinese finance ministry was looking to raise €4bn (£3.5bn) by selling a mixture of five, ten and 15-year bonds.

Extraordinarily, the auction attracted €18bn (£16bn) worth of orders, enabling China to sell the five-year bonds with a yield of -0.152%.

The bonds were issued in euros

The 10-year bonds were sold with a yield of 0.318% and the 15-year paper with a yield of 0.664%.

There are a number of specific reasons why there was such demand for the bonds.

The first reason is that Chinese bonds tend to attract investors looking for yield because they tend to offer a relatively high return compared with other government bonds.

Yields on German five-year bonds, for example, have gone as low as -0.841% this month.

Those on Swiss five-year bonds, meanwhile, have been as low as -0.762%.

Even a yield of -0.152% looks attractive by comparison.

That is especially true given that China issued this debt in euros at a time when most short-dated eurozone sovereign debt now trades with a negative yield.

The second reason is that FTSE Russell, the index provider, is set to include Chinese government bonds into its World Government Bond Index from October 2021.

That means those tracker funds seeking to replicate the performance of that index will have to start buying Chinese debt.

It follows similar moves from JP Morgan and Bloomberg and it has been speculated that as much as $150bn (£112bn) worth of foreign money could be invested in Chinese government debt during the next 11 months as a result of it being included in three major bond indices.

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Thirdly, and perhaps most obviously, is that the Chinese economy is recovering more rapidly from the disaster of COVID-19 than its counterparts in the west.

China is just about the only major economy worldwide that is likely to finish 2020 larger than it started it, with its economy growing by 4.1% during the latest quarter, having contracted by 6.8% in the first three months of the year but then grown by 3.2% during the second quarter.

Moreover, Chinese government debt is relatively scarce, which may also explain the rush.

This was only China’s sixth bond sale in four years and its second denominated in euros as many years.

Another reason why Chinese debt is starting to attract foreign buyers is the US election result.

The election of Joe Biden has raised hopes that, following the tumult of the Trump years, US-China relations can take on a more normal air once again.

The Trump administration last month banned Americans from investing in the bonds or shares of a range of companies that have contracts with the Chinese military, including Huawei, China Telecom and the IT company Inspur Group.

However, in remarks to a group of chief executives from the Asia Pacific region today, the Chinese president, Xi Jinping, insisted there would be no retaliation.

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Speaking ahead of the Asia-Pacific Economic Cooperation (Apec) summit of leaders from the region in Malaysia, President Xi insisted there could be no question of China adopting protectionist policies or trying to row back on globalisation.

He said: “China is very integrated into the global economy and the international system.

“We will not reverse our course or go against our historical trend by disconnecting or forming a small circle to leave others out.

“Openness allows a country to move forward and isolation slows it down.”

Those comments will raise hopes that Mr Biden’s election will herald a recovery in multilateral trade and a more constructive approach from the US when dealing with other countries.

If that does indeed come to pass, today’s bond auction by China is unlikely to be the last of its kind.