The bond market has encountered some turbulence since August, causing concern among investors who find themselves facing losses in their bond fundsThis raises an important question: Is the bond market still a worthy investment option? After analyzing the current landscape, the conclusion reveals a cautious but optimistic stanceDespite limited fluctuations in interest rates and a firm economic outlook—along with the central bank's evident intent to support liquidity—the allure of the bond market remains intact, mainly due to an ongoing "asset shortage" that sustains demandNevertheless, the bond market has started to exhibit a more diverse performance across different types of securities.

To better understand the dynamics at play, it's essential to differentiate between interest rate bonds and credit bondsInterest rate bonds, commonly backed by government credit, are seen as low-risk investments

Advertisements

This category primarily includes government bonds, municipal bonds, central bank bills, and policy financial bonds—which are issued by state-owned banks like the Export-Import Bank of China, Agricultural Development Bank of China, and the China Development BankThe perceived security associated with these bonds stems from their governmental backing.

On the other hand, credit bonds are issued by corporate entities, which adds layers of complexityThese can be further classified into financial bonds issued by financial institutions and corporate bonds issued by non-financial entitiesDue to the varied creditworthiness of these companies, the risk associated with credit bonds can differ significantlyGenerally, corporate bonds tend to offer higher yields compared to government bonds, with the difference in yield referred to as the credit spreadThis is calculated by combining the risk-free rate, the credit spread, and liquidity premiums

Advertisements

While interest rate bonds typically present lower risks due to their government backing, credit bonds potentially yield higher returns but come with increased risks correlated to the issuing entities’ financial health.

The recent divergence within the bond market calls for further examinationRecent trends indicate that the different categories of bonds are responding distinctively to market conditionsFor instance, between August and late August 2024, the total wealth index for state bonds rose by 0.16%, while the corresponding index for credit bonds fell by 0.15%. The stark contrast in performance highlights that credit bond funds and related investment products have been lagging compared to pure interest rate bond products.

Two contributing factors help explain this segmentation: Firstly, the adjustments in credit bonds can be attributed to a correction of earlier trends

Advertisements

As early as July, there were multiple warnings concerning risks that appeared to impact interest rate bondsA sharp decrease in market activity—evidenced by a decline in transaction volume—has left credit bonds more vulnerable to increased liquidity pressuresConsequently, some investors, nervous about these developments, opted to liquidate their positions preemptively.

Secondly, the prevailing credit spreads for credit bonds had compressed to historically low levels, making them highly sensitive to even marginal changesThroughout this year, compounded by the "asset shortage" scenario, credit spreads have continued to tighten, leading to minimal differential returns compared to risk-free alternatives like government bondsThis situation heightens the vulnerability of credit securities to fluctuations in market conditions.

Moreover, government bond issuance has accelerated in recent weeks, potentially tightening liquidity conditions

• Promoting Safe and Orderly Development of Nuclear Energy
• Nvidia Loses $240B in Market Value Overnight
• U.S. JOLTS Job Openings Exceed Expectations
• Elevating the Full Chain of China's Automotive Industry
• Anthropic Seeks $2B at $60B Valuation

From August onwards, both national and local governmental bond issuances significantly ramped up, with net financings reaching approximately ¥1.73 trillion by late AugustWhen ultra-low credit spreads coincide with tightening liquidity, the widening of credit spreads becomes a natural outcome as investors reassess risk in a modified environment.

Given these dynamics, one might wonder why investors would not instead favor the more stable policy financial bondsThese bonds, issued by policy banks, enjoy excellent credit ratings and stable coupon payments, rendering them akin to government securitiesInvestment products like the middle-term policy financial bond ETF closely track the associated index, chiefly focusing on bonds with seven-to-ten-year maturities.

There are several compelling reasons why policy financial bonds warrant attentionFirst, these bonds entail minimal credit risk since they are issued by established state-backed entities, avoiding concerns typically associated with corporate defaults

This characteristic renders such bonds a "safe haven" in the wider bond marketSecond, they promise attractive coupon rates, providing a reliable income stream that is particularly appealing for risk-averse investors.

Lastly, the duration of seven-to-ten years intensifies their sensitivity to shifts in interest ratesIn a declining interest rate environment, these bonds present considerable potential for capital gains as their prices riseTherefore, I believe that the bond market may continue to exhibit narrow fluctuations until additional policies are implementedWhile temporary market disturbances might seem daunting, they do not undermine the inherent stability of the bond marketIn fact, this presents a prime opportunity for investors to seize the moment and bolster their portfolios in anticipation of a gradual uptrend over the long term.

In this context, I find the seven-to-ten-year policy financial bonds particularly appealing