The bond market plummets, not worried about stocks but about redemptions

Core Viewpoints

This week, the stock market experienced fluctuations and consolidation, while the bond market continued its weak performance from last week. Today's decline further expanded, with the ten-year government bond falling below the 1.8% threshold, and the thirty-year government bond adjusting to a year-to-date high of 2.1%.

There were not many negative fundamental news this week; today's inflation data was slightly below expectations, and the stock-bond seesaw effect was not obvious. The turmoil in overseas situations and the Federal Reserve's interest rate cuts provided slight benefits to bonds. However, the bond market showed a clear dullness to the positive news, with interest rates continuing to rise, seemingly mainly reflecting the impact of institutional behavior. So, what are investors worried about? What is the underlying logic?

Bond funds, as the most professional, standardized, and research-capable institutions in the market, have made significant progress over the past few years. The expansion of inter-industry cooperation is not only due to tax exemption advantages but also due to complementary resources and capabilities (research, financing, etc.), which have promoted and invigorated the bond market, enriched the multi-tiered capital market, and improved market pricing efficiency.

Last Friday evening, the China Securities Regulatory Commission released the "Regulations on the Management of Sales Expenses for Publicly Raised Securities Investment Funds (Draft for Comments)." This new regulation reduces investor costs, standardizes sales order, and guides long-term investment, which has very positive implications.

However, the unexpected point lies in the regulations on redemption fees for bond funds, which state that regardless of whether it is an equity fund, bond fund, or mixed fund, if the holding period is less than 7 days, the redemption fee rate shall not be less than 1.5%; for 7 to 30 days, not less than 1%; and for 30 days to 6 months, not less than 0.5%. ETFs, certificate of deposit funds, and money market funds are exempt. If this regulation is strictly implemented, it will have several impacts:

1. Bond funds, especially short-term bond funds, are representatives of inclusive finance, serving as investment and liquidity management tools for various investors, which is fundamentally different from equity funds. Once redemption fees increase, the cost-effectiveness will be significantly weakened.

2. After several years of bull markets, the investment experience in bond funds, especially interest rate bond index funds, has been poor this year, with low returns and high volatility, which has also created redemption pressure.

3. With the stock market shifting to fluctuations and consolidation, it is not ruled out that some absolute return investors may also choose to redeem mixed products and secure profits.

Although funds redeemed from bond funds will also be invested in bonds, banks' proprietary trading prefers medium to short-term interest rate bonds, while wealth management prefers short-term credit bonds. It is not difficult to see that the demand for public bond funds, which are heavily invested in perpetual bonds, policy financial bonds, and ultra-long-term interest rate bonds, will weaken. The decline in medium to short-duration and ordinary credit bonds is relatively small. This also aligns with our strategy recommendations in recent weeks, which suggest avoiding ultra-long bonds and perpetual bonds, and looking for a steep curve.

In addition to the above factors, the current coupon protection is too low, forcing institutions to turn to trading, leading to weak market sentiment, which tends to favor swing trading at the slightest disturbance.

At the beginning of this year, the bond market had already overdrawn interest rate cut expectations, with only a brief trading opportunity in mid-March; for the rest of the time, the ten-year government bond has basically fluctuated around 1.7%, resulting in a poor holding experience. The opportunities for "micro-operations" have significantly decreased, making it difficult for the accumulation of bond market coupons to withstand capital gains losses caused by interest rate fluctuations, resulting in inefficient investments.

In contrast, the stock market and precious metals have entered a bull market with lower volatility, and overseas bonds at least offer higher coupons, while the Sharpe ratio of domestic bonds is relatively low among various assets For banks, the interest margin has already narrowed this year, and loan issuance is difficult to increase, leading to significantly greater profit pressure, with less room for maneuver in OCI accounts. Financial market operations have shifted from contributing to profits last year to dragging down profits this year, making it easier to see redemption and profit-taking behavior at the end of the quarter, further amplifying market volatility.

Of course, the fading macro narrative such as deflation also objectively requires interest rates to find a reasonable position again.

It is not difficult to see that the current adjustment in the bond market has a fundamental background, but institutional behavior is more direct; how to judge the timing and space?

First, the impact of institutional behavior or redemptions is often fierce but short-lived, creating opportunities for overshooting. The funds for bond investment do not disappear during the redemption process but rather return to the balance sheet or flow into wealth management. Against the backdrop of insufficient real financing demand, the financial system finds it difficult to truly shrink its balance sheet; the demand for allocation still exists, and interest rates still have a ceiling.

Second, the fundamentals are the foundation of the bond market; as the logic of deflation fades, the bond market needs to reposition itself. However, short-term inflation remains low, the real estate sector continues to bottom out, and financing demand is weak.

In addition, recent overseas political situations and tariff disturbances are also conducive to a decline in risk appetite. After a previous sharp rise, the stock market has entered a consolidation phase, with a stable funding environment, and the short end of the curve has a certain restraint on the long end.

Fourth, insurance and other allocation funds are beginning to accept ultra-long government bonds with yields above 2.0%. However, the new funds from these sources are limited, and the pressure of under-allocation is not significant, making it difficult to support the market alone. Trading funds need to see downward space to be motivated.

Therefore, in terms of timing, a true turning point still requires coordination with fundamentals, the stock market, and the implementation of new regulations. After October, the high base of fundamental data, stock market sentiment, and the off-season for supply may resonate better, at which point opportunities for a rebound in the bond market can be sought.

In terms of space, we reiterate that the 10-year government bonds (old bonds) at 1.8-1.9% can start to be considered for allocation. If there is an impact from institutional behavior or it reaches the mid-March high of 1.9%, it is recommended that trading funds seize trading opportunities. After today's adjustment, the odds in the bond market have improved.

In terms of varieties, 30-year government bonds and perpetual bonds are likely to become amplifiers of market trends in adverse conditions and should still be avoided. Government and financial bonds are also subject to potential impacts and will perform weakly. We continue to focus on interest rate bonds with maturities of 5-7 years and below, as well as short- to medium-term credit bonds.

In the long term, we reiterate that profound changes are occurring in the industry ecosystem, combined with changes in macro narratives and the price effect of major asset classes, interest rates should be reassessed in the long run. We made a judgment on the long-term trend of interest rates in February this year, which can still serve as a reference. The difficulty of re-inflation remains high, but if the logic of deflation fades, short-term interest rates will still benefit from a loose funding environment, while the pricing anchor for ultra-long-term interest rates should be before November last year.

Authors of this article: Zhang Jiqiang, Wu Yuhang, etc., Source: Huatai Securities Fixed Income Research, Original Title: "【Huatai Fixed Income】Not Afraid of Stocks but Afraid of Redemptions"

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