Bond Market Turmoil in China: Short-Term Pain for Long-Term Gain? 1

Yield curve inverts

Earlier in May, the government bonds yield curve in China inverted for the first time since records have been kept. This event occurred as a result of the five-year government bond yield rising higher than that the 10-year bond. In the graph above, the inversion is depicted by the spread between the five and 10-year bonds moving into negative territory.

Generally, a yield curve always slopes higher for longer-maturity tenors as market participants are rewarded with a higher yield for committing to hold a longer-term bond. However, if yield on a shorter-term maturity bond becomes higher than that of a longer-term bond, the yield curve is said to have inverted.

An inverted yield curve generally means that investors are bearish about the long-term growth prospects of the country in question.

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Deleveraging the reason

The government has been cracking down on the shadow-banking system in the country. This has resulted in reduced liquidity, along with concerns over further measures that could be taken, leading to a sell-off in the $1.7 trillion government bond market.

The five-year note, which is more illiquid than the 10-year bond, has thus borne the brunt of the selling as investment managers have been offloading them from their portfolios in order to ensure that they do not get stuck with the notes in case the situation in China deteriorates.

For the better?

An upward sloping yield curve remains a desirable prospect. Given that China is facing an inverted yield curve, which would become flat at best, should the country’s bonds remain out of bounds?

Investors should be careful about investing in the country’s corporate bonds and instruments that invest in them. The primary reason being that in case of any undesirable developments, the already leveraged corporate bond market may face grave liquidity issues.

However, for financial markets in general, the measures being taken are important to cleanse the financial system and make it more appealing to investors. This would mean that the country’s government bonds will remain in turmoil for some time. Those with a short-term outlook should keep a distance, however, those with longer-term views would likely appreciate these efforts to instill confidence in investors.

This would only support China’s candidature for complete inclusion in global equity and bond indices, something that the government and regulators are themselves dedicated to pursuing.

Speaking of financial markets, we’ll look next at how the recent bond market turmoil has impacted instruments investing in them and what value remains in the country’s bonds.

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