Biggest Bond Slump Since ‘04 Not Over, Zeng Says: China Credit

China’s bonds are unlikely to recover from the biggest slump in six years until at least March as the government raises interest rates to curb inflation, according to the manager of the country’s best-performing fixed-income fund.

“The current wave of selling is justified given inflation is such a big concern,” said Zeng Gang, who manages 3.4 billion yuan ($507 million) at Harfor Fund Management Ltd. in Shanghai. “Yields will remain high in the next three months. The market is reflecting the right level of pessimism.” His $332 million Huafu Income Growth Fund has returned 14.9 percent this year, the most among 138 China bond funds tracked by Bloomberg.

Yuan-denominated government notes dropped 1.5 percent in November, their worst performance since April 2004, according to an index compiled by HSBC Holdings Plc. The securities gained 1.2 percent this year, the least among BRIC-nation debt, according to JPMorgan Chase & Co. indexes. The yield on China’s benchmark 10-year bonds reached 4.02 percent on Nov. 29, the highest level since September 2008.

The People’s Bank of China raised lenders’ reserve requirements twice last month and announced in October the first interest-rate increase since 2007, seeking to tame inflation as prospects for yuan appreciation attract funds from abroad. The central bank will lift its one-year lending and deposit rates by a percentage point before the end of 2011, according to the median forecasts of economists surveyed Dec. 2 by Bloomberg.

10-Year Yields

Borrowing costs may be raised two or three times by March, Harfor’s Zeng said in a Dec. 3 interview, declining to provide yield forecasts. Local-currency government bonds in Brazil have handed investors a 12.2 percent return this year, while notes in Russia gained 10.5 percent and India’s 4.5 percent, JPMorgan Chase & Co. indexes show.

The yield on China’s 10-year government debt is likely to climb to 4.5 percent by mid-2011, from 3.91 percent yesterday, according to HSBC Private Bank and DBS Group Holdings Ltd. HSBC forecast a percentage point of policy-rate rises by the end of next year and DBS, Southeast Asia’s largest lender, predicted 1.25 percentage points of increases.

“Chinese inflation will peak somewhere close to 6 percent and it will probably keep rising in the first half of next year,” said Arjuna Mahendran, the Singapore-based head of investment strategy for Asia at HSBC Private Bank, which oversees $460 billion globally. The “bearish trend” for bonds will continue in coming months as policy makers tighten monetary policy, said Jens Lauschke, a fixed-income strategist at DBS in Singapore.

Inflation Outlook

Consumer prices in the world’s second-largest economy probably increased 4.7 percent last month, the most since August 2008, according to the median forecast of 29 economists surveyed by Bloomberg before government data on Dec. 11. December’s gain will be below 5 percent and less than November’s level, the China Securities Journal reported Dec. 6, citing Zhou Wangjun, deputy director of the pricing department at the National Development and Reform Commission.

China may hold its annual economic work conference on Dec. 10-12, which will set guidelines on monetary and fiscal policies for 2011, the Xinhua News Agency reported Dec. 3. The NDRC may meet Dec. 14 to set economic growth and inflation targets for next year, the 21st Century Business Herald reported yesterday, citing a person familiar with the matter it didn’t identify.

Cash Injections

Ten-year yields dropped 10 basis points last week, the most since July, as the central bank reined in bill sales to help ease a cash shortage stemming from increases in lenders’ reserve ratios. The People’s Bank of China injected 166 billion yuan into the financial system in the last three weeks via open-market operations.

“Some investors have started trading on the opportunity after yields rose recently to relatively high levels,” said Diao Yu, who co-manages a 3 billion-yuan bond fund at Fullgoal Fund Management Co. “I think there are still risks from economic fundamentals and liquidity conditions.”

Fullgoal, based in Shanghai, oversees China’s second- and fourth-best funds of this year, which have delivered returns of 14 percent and 13.4 percent, according to data compiled by Bloomberg.

China’s onshore bond funds posted a 1.1 percent loss in November, ending a four-month winning streak, based on average returns of the 138 funds tracked by Bloomberg. That was their worst month since a 3.1 percent decline in August 2009. For the year, the funds are up 6.9 percent.

Swaps, Yuan

One-year interest-rate swaps based on the floating seven-day repurchase rate were 3.03 percent as of 3 p.m. in Shanghai, 36 basis points lower than a two-year high of 3.39 percent reached on Nov. 29, according to Bloomberg data. The rate surged by a record 83 points in November.

The yuan weakened 0.3 percent today to 6.6628 per dollar, its biggest loss in a month. The currency has strengthened 2.5 percent since a two-year peg ended on June 19, and 12-month non-deliverable forwards reflect bets for a 2.2 percent advance in the coming year.

Five-year contracts on the nation’s debt climbed one basis point yesterday to 71, according to CMA prices in New York. Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a government or company fail to adhere to debt agreements.

Guangdong-based E Fund Management Co. Ltd., which had 200 billion yuan of assets at the end of March, aims to add to its holdings of Chinese bonds in the next three months.

‘Overly Pessimistic’

“Bond prices are already reflecting an overly pessimistic” view on monetary policy, said Xide Ma, a Beijing- based fund manager whose E Fund Monthly Income Fund was China’s best performer in November. “We are looking to buy. We think the government bond market will get better and we like the five-to 10-year bonds.”

The Communist Party’s Politburo, meeting Dec. 3, signaled it plans to tighten monetary policy in the coming year while sustaining economic growth. Officials “will adopt proactive fiscal policies and prudent monetary policies,” the state-run Xinhua News Agency said. Policy makers had previously used the term “moderately loose” for the central bank’s stance.

Speculation that interest rates will rise by year-end will likely damp demand for bonds, making any rebound in December fleeting, according to Zhou Ming, who manages about 300 million yuan of bond funds at SYWG BNP Paribas Asset Management Co. in Shanghai.

“A big decline in bond yields is impossible in December because of tight cash conditions at banks,” said Zhou, whose SYWG BNP Paribas Bond fund has gained 12.1 percent this year. “Ten-year yields at 4 percent may indicate value for buy-and-hold investors, but it doesn’t signal a trading opportunity.”

Before it's here, it's on the Bloomberg Terminal. LEARN MORE