The bond market in China has recently experienced a notable decline, particularly characterized by a significant pullback in short-term yieldsA closer examination reveals that the yield on one-year government bonds rose by 13 basis points last week, settling at 1.19%. Furthermore, the yields on ten-year bonds increased by 7 basis points, reaching 1.65%, while thirty-year bonds saw a slight uptick to 1.87%. This shift indicates that the current environment is not only challenging for investors but also reveals underlying changes in both fundamental and liquidity dynamics affecting the market.

Several fund management firms have pointed out that these movements can be attributed to marginal changes in both fundamental factors and liquidity conditionsA critical aspect of this change was highlighted by the resurgence of the core Consumer Price Index (CPI) in December, which increased by 0.4%. Concurrently, non-farm employment data from the United States exceeded expectations, casting a somewhat negative light on the domestic bond market

On the liquidity front, the People’s Bank of China (PBOC) announced a temporary halt on the purchase of government bonds in the open market, signaling a desire to avoid excessive downward pressure on interest rates.

One intriguing trend is emerging amidst a low yield environment—a phase where the bond market's potential for growth is limited, but volatility may riseMany investors are opting for a strategy described as “acceptable winning probability but low payoff.” This approach involves incorporating bond-like assets such as convertible bonds and dividend stocks into fixed-income portfolios, reviving interest in the “fixed income plus” strategy.

The marginal changes affecting both fundamental and liquidity factors are critical to understanding the recent bond market adjustmentsOn January 9th, the National Bureau of Statistics released data concerning the national CPI and Producer Price Index (PPI) for December 2024. This data indicated that the PPI declined by 2.3% year-on-year, which represented a narrowing of the decline by 0.2 percentage points from November, while showing a month-on-month drop of 0.1%, outperforming market expectations

The CPI saw a slight year-on-year increase of 0.1%, with the core CPI (excluding food and energy) also seeing a rise of 0.4%, maintaining an upward movement.

According to Wu Gang, Deputy Director of Fixed Income Research at HSBC Jintrust Fund, the seasonal slowdown in industrial production in December impacted the PPIThe stability in industrial production prices suggests a modest recovery, despite weak CPI performance largely attributed to declining food pricesHowever, the increasing core CPI hints at a potential steady rise in future core inflation due to continuous policy support.

On January 10th, the Central Bank announced its decision to pause government bond purchases due to increasing demand in the marketThis decision led to a sharp decline in bond futures on that dayWanji Fund’s Chief Macro Analyst, Xiong Yiming, indicated that this pause was aimed at curbing excessive drops in interest rates

This approach aligns with the PBOC's previous stance on monitoring long-term yield changes while mitigating risks associated with capital arbitrage.

Many agencies had pre-emptively adjusted their portfolio strategies in anticipation of a transitional phase in the bond market as it approached the new yearThe PBOC’s decision to suspend bond purchases is seen as an effort to stabilize supply and demand dynamics in the government bond market, thereby preventing a rapid decline in bond yields.

Investors have observed a simultaneous increase in bond yields, leading to a correction in bond fundsAccording to Wind data, over 80% of bond funds witnessed declines last week, with many funds experiencing weekly drops exceeding 1%. As volatility increased and net values of bond funds retreated, several funds faced substantial redemptions, necessitating adjustments to their net value accuracy

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As of January 10, five bond funds had to announce increased accuracy for fund unit net values due to these circumstances.

Xiong Yiming predicts that short-term fluctuations may characterize the bond market as the PBOC remains resolute in its intentionsShould rates continue to decline, it is likely that more measures will be implemented by the authorities to guard against an unchecked descentHe observed that the PBOC's decision to pause bond purchases mainly impacts short-term bonds, with minimal direct consequences on longer-term bonds, which have remained a subject of expectation since the PBOC began bond transactions last AugustThe recent declines in short-term yields appear inconsistent compared to the rates of bank deposits and other government bonds, suggesting a potential rationalization in yield spreads once the purchasing pauses are lifted.

From a broader perspective, Xiong believes that there is limited upside potential in bond yields overall as 2025 unfolds

Several factors contribute to this sentiment: firstly, the strong demand for configurations at the year's onset indicates a persistent supply-demand imbalance where government bonds remain in high demand; secondly, the PBOC’s decision to pause is not indicative of a large-scale sell-off; and thirdly, as the economy enters recovery, the central bank's inclination towards a moderately accommodative monetary policy will ensure that their control over the market remains strategic and measured in nature, signaling continued support for economic revival initiatives.

Similar viewpoints were expressed by the fixed income team at Xingyin Fund, which anticipates that while bond yields will largely stay low in the face of a lack of substantial growth momentum, supply shocks and constrictions in monetary policy capabilities will cap the extent of further declinesAccordingly, maintaining a neutral duration and leverage in portfolios while increasing exposure to mid-to-long-term bonds could enhance revenue performance via strategic trading.

Morgan Stanley Fund summarized that the bond market trend for 2025 will be maintained, albeit with heightened volatility factors

While the probability of profitable outcomes may seem plausible, the payoff is limited, leading to a recommendation for a careful balance in investment timing and strategies.

From the asset allocation viewpoint, bond funds continue to represent a cornerstone of low-risk investmentsHowever, given the current low-interest-rate landscape, which restricts upward potential alongside potential volatility increases, many funds are now emphasizing the combination of traditional bonds with convertible bonds or dividend-paying stocks to enhance yields—a clear revival of interest in the “fixed income plus” investment strategy.

AXA SPDB Investment Managers recommends two primary strategies for investors looking to allocate into bond funds: the first focuses on medium to short-term bonds, appealing to investors who prioritize lower risk and volatility while seeking an optimal investment experience

In fact, since the inception of the short-term bond fund index, its annualized volatility stands at a mere 0.44%, with maximum drawdown confined to just -0.50%, significantly outperforming medium and long-term bond fund indices over the same period.

The second strategy is aimed at investors willing to endure more significant drawdowns in hopes of securing comparatively higher returns by blending “pure bonds” with alternative assetsThese may include combining pure bond holdings with convertible bonds in primary bond funds, or blending pure bonds with equities in secondary bond fundsSuch funds maintain a predominant bond allocation while employing select convertible bonds and stocks to achieve better portfolio elasticity.

Furthermore, CICC recently highlighted in their reports that the low-interest-rate era offers three potential pathways for breaking through traditional constraints within fixed income funds: first, emphasizing short-duration categories as they benefit from falling short-end rates amidst shifting investor behaviors towards deposits and financial products; second, bolstering equity components in conjunction with fixed-income holdings for wealth enhancement, including increasing focus on QDII bond funds and trading-oriented bond products; and last but not least, recognizing that flexible investment categories are set to capitalize on growth opportunities within the equity market, advocating for technology or growth sectors and tapping into alpha-generating capabilities through stock selections and convertible bonds.”