The Future of Bond Yields

As the second half of the year approaches, analysts predict an increase in the supply of bonds, while demand from various institutions continues to remain robustIn the current environment characterized by low interest rates, it becomes imperative for market investors to strike a delicate balance between short-term and long-term strategies, considering both returns and associated risksThis balancing act requires an acute awareness of the present economic climate while also managing the implications for future investment.

The first half of the year witnessed a sustained bullish trend in China's bond market, with the yield on 10-year treasury bonds plummeting to an all-time low of 2.226% on April 23. This was the lowest yield seen since April 27, 2002. Following this decline, yields experienced some fluctuation, reaching a high of 2.336% on May 11 before again retreating

By June 28, yields dipped again to around 2.206%, which marked a cumulative decline of 35 basis points since the start of the yearIn comparison, the one-year treasury bond yield also decreased, falling by 54 basis points to 1.54%, significantly outpacing declines in longer-term bonds.

Several factors contribute to the persistent downtrend in bond yields, including disappointing economic fundamentals, a lenient monetary policy set by the People’s Bank of China (PBOC), declining central rates, a slower-than-expected pace of government bond issuances, and adjustments in deposit rates by smaller banksThese changes have resulted in a significant migration of deposits into wealth management products and funds, exacerbating the asset scarcity pressures faced by non-bank institutions and fueling strong demand for bonds.

Given that the present bull market in bonds is driven largely by an imbalance in supply and demand, coupled with substantial asset scarcity, the key to predicting future movements in the bond market lies in examining both these facets comprehensively.

The governmental bond supply is anticipated to witness an uptick in the coming months

• The Fall of German Auto Giants
• The Three Phases of Cheetah Mobile
• Satellite Industry Enters Commercialization Era
• Treasury Yields Rise Amid Asset Scarcity
• Maintaining Cost-Effectiveness in Public Bonds

In the first half of the year, the net supply of interest-bearing bonds was reported at 4 trillion yuan, representing a decrease of 901.7 billion yuan compared to the same period in 2023. A report released by the State Council on June 25 highlighted that certain specialized bond projects had faced delays in approval or did not meet required financial thresholds, contributing significantly to the sluggish issuance of government bonds during the first half.

Looking ahead to the second half, there is an expectation for a slight increase in net supply from local bondsThe approval processes for specialized bond issuances are expected to become more structured and cautious, leading to a potential slowdown in bond issuances compared to expectationsIn the first half, local government bonds had a cumulative net issuance of 1.8725 trillion yuan and are projected to meet a demand surplus of 2.7475 trillion yuan for 2024. However, with approximately 1.3555 trillion yuan maturing in the latter half of the year, it is estimated that a total of 4.103 trillion yuan in local bonds will be issued, but due to more stringent project approvals, the actual issuance may be adjusted down to approximately 3.2824 trillion yuan, resulting in net financing of 1.9269 trillion yuan—an increase of 544 billion yuan compared to the first half.

Institutional demand for bonds remains strong

On June 19, PBOC Governor Pan Gongsheng emphasized during the Lujiazui Forum that the central bank would continue its supportive monetary policy stance, focusing on both counter-cyclical and cross-cyclical adjustmentsThis suggests that the PBOC intends to maintain a favorable liquidity environment to support economic recovery.

The newly emerging growth drivers of China's economy still require time to mature, thereby necessitating a continued easing of monetary policy alongside ample liquidity in the marketThe banks, in their lending practices, are shifting away from a focus on sheer scale and are instead prioritizing the optimization of existing assets, which has led to reduced inventory usageConsequently, this creates a favorable environment for institutional leverage in purchasing bondsMoreover, the demand for government bonds from banks has surged due to relatively low market rates for funds.

Additionally, the domestic stock markets have been under strain, with the so-called seesaw effect driving more investments into bonds

With investor confidence in the stock market wavering, as evidenced by the Shanghai Composite Index dropping 6.4% from its high of 3171 points on May 20, sentiment remains cautious, which bodes well for the bond market.

Furthermore, restrictions placed on banks to offer high-interest deposits, combined with continuous lowering of bank deposit rates, are channeling funds toward asset management and mutual fundsThis ultimately forces market players that formerly relied on high-yield deposits to re-evaluate their asset allocation strategies, which is likely to persist in the near futureNon-bank financial institutions are enjoying excess liquidity, as shown by the seven-day repo rate spread tightening from 22 basis points in March to a significant narrowing to between 3 and 9 basis points in May and June, respectively, which indicates high demand for bonds, particularly credit bonds.

Significantly, reports from financial media outlets have indicated that several insurance companies are expected to lower the interest rates on life insurance products from July 1 onwards to 2.75%, while ceasing offerings at the existing 3% rates, potentially prompting short-term purchasing activity as consumers rush to secure higher yields before products are revised

This could enhance the pressure on insurance institutions to align their allocations with long-term bonds.

The peak in government bond supply is expected between August and October, which suggests that the bond supply in July might only provide temporary relief to existing asset scarcityFollowing the anticipated bond supply surge in the latter part of the year, bond yields may experience a rebound, dependent on the economic recoveryShould conditions improve beyond expectations, market risk appetite could heighten, causing bond yields to trend upwardsOn the other hand, if the economic conditions remain bleak, bonds might revert to a bull market status.

Investing in bonds during a period of low interest rates carries its own set of risksLessons from the experiences of banks like the Silicon Valley Bank and Japan's Norinchukin Bank must be heeded when formulating strategies in such scenarios.

These banks opted for extending the durations of their bond investments to boost returns in a climate where corporate borrowing was tepid and bank lending diminished

However, as bond yields began to rise, the cost of funding for these banks escalated, leading to widening discrepancies between asset yields and liabilities, heightening the risk associated with maturity mismatchesIf discrepancies worsen, banks may be forced to liquidate low-yield bonds at a loss, jeopardizing their operational stability.

The decisions made by these institutions in a low-rate environment may have provided short-term solutions but laid the groundwork for latent long-term risksThis is likely the catalyst for the central bank's repeated warnings regarding the vulnerabilities associated with persistently low long-term bond yieldsAfter the yield on 10-year treasury bonds breached the 2.20% mark again on July 1, the PBOC announced it would conduct treasury borrowings from select primary dealers soon afterFollowing this announcement, bond yields spiked by 4 to 5 basis points that day, demonstrating the central bank's intent to influence market rates through strategic borrowing and sales of treasury bonds and to mitigate the risks associated with prolonged low yields.

In this landscape of low interest rates, market investors must cultivate a strategy that considers both short-term and long-term perspectives, adeptly navigating the balance between return and risk while remaining conscientious of ongoing developments in the economic environment.