Cheapest Stocks to Bonds in Five Months Lure Funds: China Credit

The last time Chinese stocks were this cheap relative to bonds, the Shanghai Composite Index rallied 18 percent within two months. The prospect of history repeating itself is luring some fund managers back to equities.

The earnings yield for the Shanghai index was 3.46 percentage points higher than the average yield on top-rated 10-year corporate bonds on May 2, according to data compiled by Bloomberg. The valuation gap was last that high on Dec. 13. The ChinaBond Corporate Bond index fell in the week ended April 26 amid a probe into trading violations, ending a 25-week winning streak that was the longest since at least October 2008.

Lombarda China Fund Management Co. is favoring equities because a pickup in inflation may curb bond returns, said La Bo, its Shanghai-based chief strategist. The central bank last week said that it can’t be “blindly optimistic” on living costs, after consumer prices accelerated more than forecast last month. Everbright Pramerica Fund Management Co. said it may boost stock allocations after the Shanghai Composite slid 7.7 percent from this year’s high on Feb. 6.

“Equity assets are more attractive and the return could be better” than corporate bonds, Tian Dawei, its chief strategist in Shanghai, said in a May 7 e-mail interview. “We’ll consider adding to equity assets,” he said. Everbright Pramerica, a joint venture with Prudential Financial Inc. that manages $4.9 billion, had an 81 percent allocation for equities at the end of the first quarter.

The rally in the Shanghai Composite faltered shortly after it entered a bull market on Jan. 29 and the index has fallen 1 percent this year on concern government measures to cool housing prices will curb earnings growth. First-quarter profit at 53 percent of the companies in the index missed estimates, according to data compiled by Bloomberg. Local-currency debt has delivered a 2.3 percent return in 2013, Chinabond data show.

Stock Valuations

The benchmark stock index is valued at 12.1 times reported earnings, a 28 percent discount to the five-year average of 16.9, Bloomberg data show. Its average earnings yield is 8.3 percent, exceeding the 5.1 percent yield on the top-rated 10-year corporate bonds.

The ChinaBond Corporate Bond index dropped 0.1 in the week ended April 28 amid the central bank’s probe into the $3.7 trillion interbank bond market. The People’s Bank of China asked market participants to examine trading histories as it cracks down on short-term transactions designed to bypass month-end risk evaluations, two people with knowledge of the matter said last month.

Bond Performance

One-year government bonds fell last week, with the yield rising six basis points to 2.83 percent as of May 10, Chinabond indexes show. The yuan has risen 0.2 percent this month to 6.1479 per dollar as of 11:50 a.m. in Shanghai, spurred by capital inflows.

Chinese stocks may rebound 20 percent this year as economic growth recovers and liquidity is loosened, Chen Li, Shanghai-based head of China equity strategy at UBS AG, said at a media briefing on May 8. Property developers and consumer industries such as autos and home appliances may benefit most, he said.

A gauge of 24 real-estate companies in the Shanghai index offer an average earnings yield of 10.6 percent, the second-highest among the five industry groups, data compiled by Bloomberg show. China Vanke Co. and Poly Real Estate Group Co., the nation’s two biggest developers, each have a yield of 9.9.

The yield on 10-year bonds with an AAA rating has slumped to 5.10 percent this year from 5.29 percent at the end of 2012. The spread over government securities narrowed to 168 basis points from 171. Yuan corporate bond sales in the nation surged 38 percent this year to 1.57 trillion yuan ($256 billion).

Mixed Data

Recent economic reports are showing mixed signals. Manufacturing slowed last month, while exports grew faster than expected. Consumer prices rose a higher-than-estimated 2.4 percent in April, while producer prices dropped more than forecast, the National Bureau of Statistics said on May 9. The government has set goals of 3.5 percent inflation this year and economic growth of 7.5 percent.

“The shape of the economy will be similar to slight stagflation as inflation picks up and growth remains weak in the following two quarters,” Lombarda China Fund’s La said in an e-mailed response to questions from Bloomberg News on May 6. “Stocks are expected to deliver higher returns than bonds.”

Lombarda China, a venture with Unione di Banche Italiane SCPA, allocated 30 percent of its $1.6 billion in assets in fixed-income products at the end of the first quarter.

Slowing Growth

China’s expansion slowed to 7.7 percent in the first three months of the year from 7.9 percent a quarter earlier, as industrial output weakened and the government’s anti-corruption drive took its toll on consumption. Net income for industrial companies increased 5.3 percent in March from a year earlier, down from a 17.2 percent pace in the first two months, the National Bureau of Statistics said on April 27.

The nation’s top leaders Xi Jinping and Li Keqiang, who took office in March, are signaling increased tolerance of slower growth as the nation reduces reliance on investment and exports. Central bank governor Zhou Xiaochuan said on April 20 that the slowdown in the first quarter is “normal” as the economy sacrifices growth to make structural reforms.

HSBC Jintrust Fund Management Co. and Golden Eagle Asset Management Co. are favoring bonds over stocks on concern the slowdown will deepen.

“Bonds are more attractive than stocks,” Liu Hui, Shanghai-based fund manager at HSBC Jintrust, which manages $1.2 billion, said in an e-mail interview on May 7. “The economy is at the bottom of the cycle and there are no signs of a recovery.”

Bond Outperformance

The company, a venture between the asset management unit of HSBC Holdings Plc and Shanxi Trust Corp., declined to say what bonds it’s buying.

“Bonds will outperform stocks this year,” said Qiu Xinhong, a bond fund manager at Golden Eagle in Guangzhou. “The economy doesn’t look good and inflation still remains controlled. It’s possible that the central bank will cut interest rates before the end of this year.”

Slowing growth has pushed up the cost of insuring the country’s sovereign notes. Five-year credit-default swaps rose four basis points this year to 70.5 basis points on May 9. The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent if a borrower defaults.

Citic Securities Co., China’s biggest listed brokerage, last week recommended investors increase their stock holdings as slowing growth prompts the government to accelerate liberalization of the economy. In a State Council meeting chaired by Premier Li on May 6, the government pledged measures to eliminate some administrative approval processes and guide private investment in local railways.

“For the time being, there isn’t a systemic risk facing the economy though property policies can restrain the expansion,” said Lombarda China’s La. “Stocks are expected to return more than bonds if the opportunities in the market are taken advantage of.”