The Big China Play Is in Bonds, Not Stocks

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China’s authorities are under pressure. The Chinese economy is slowing and can’t seem to stabilize. So what do they do? What everyone else has done under the same circumstances: They inject money into the economy, and they slash rates. That, of course, creates opportunities, but rather than what conventional wisdom would suggest, the opportunities lie not in Chinese stocks but in bonds.

Chinese Bonds vs. Stocks

True, when it comes to Wall Street, stocks seem like a better long-term investment at the moment. With the Fed rate hikes possibly hurting bond prices, stocks on Wall Street can continue to rally for a while, even after a rate hike.

But what about China? The situation is different there. Despite efforts by the Chinese central bank, the People’s Bank of China (PBoC), to stimulate the economy, and the Chinese authorities increasing investment in infrastructure to raise growth, it is unclear how profitable Chinese companies — traded either in Shanghai or Hong Kong — will be.

On the other hand, this is exactly when bonds make a more favorable investment. You see, when times are good, you want to be a stockholder, and gain alongside the company. But what about when things are uncertain? You want to be the creditor — the bondholder, in other words — and receive the principal and payment every quarter.

But that’s not the only reason why Chinese bonds are now more attractive than stocks. Realistically, when you think about it, when the PBoC injects liquidity and cuts rates, the first thing that happens is that companies have more liquidity, and that makes them more solvent, which makes bonds safer. It says nothing about the profitability of those companies — again, making the case for bonds.

Not only that, but with bonds in China and emerging markets trading at lows that haven’t been seen in a while, a fair yield of 4.77% for an average of maturity of five years is much higher than in developed markets, and certainly more risky. However, as you will have noticed from the 14% crash in the Shanghai Index back in July, this has been true for Chinese stocks as well, with stocks in China proving to be more risky than U.S. stocks.

Just a quick comparison between the two emphasizes exactly how Chinese bonds behave better during uncertainty. When we compare the PowerShares Chinese Yuan Dim Sum Bd ETF , which holds only Chinese corporate bonds with a high rating, against the iShares China Large-Cap ETF , which follows Chinese large caps, we can see that while the Chinese Bond ETF lost roughly 1.2% year-to-date, not including interest payments, the FXI lost a staggering 8.6%. This illustrates that those who were Chinese bondholders of the same Chinese companies fared better during difficult times. So you can hold your head above water when times are tough in China, while being rewarded with a higher yield.

Bonds ETFs to Play China

After our ETF comparison above, you might guess that when we say Chinese bonds, we mean Chinese bond ETFs, which enable you to get the best mix of bond risk and duration, to optimize the result and spread the risk.

But there isn’t any one way to play Chinese Dim Sum bonds in the ETF space. You can either own an ETF that specializes in Chinese bonds, or you can buy an ETF that allocates to emerging market bonds, China among them.

The main difference is that an ETF that focuses on China, such as DSUM, has less diversification in terms of exposure, because it’s all “made in China.” But if you buy an ETF such as the SPDR Emerging Markets Corporate ETF , you have exposure to Chinese bonds diversified with bonds from other domiciles, such as Mexico or Brazil.

Which is better? It depends on how much exposure to China you really want. But here’s the thing: although nothing is ever certain in investments, when it comes to investing in China — at least, when you buy Chinese bonds — you know the reward you’re getting by taking more risk. As Chinese stocks have recently proved, sometimes, after all this risk, you get no return or — worse — you lose your money.

Nikolai Kuzentsov

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