Government and some top-quality corporate bonds in the US, Europe and Japan now trade at negative yields. US junk bonds on average yield less than 4% for the first time in history.
The central banks’ binge-buying of securities has wiped yield out of the fixed income markets, leaving pension funds, insurance companies and individual retirees in a quandary. There’s no source of income in the market except for stock dividends and rent, and both are risky.
To paraphrase the 1930’s radio thriller, “The Shadow,” who knows what evil lurks in the hearts of equities? The market knows. At least the market brings to bear all the information that the public has (and some that it doesn’t).
Options prices are the standard gauge of market risk. If you think that a stock will move a great deal in one direction or another, you’ll buy an option. If you know something that everyone else doesn’t and want to maximize your gain, the options market is the weapon of choice.
Judging by the normalized price of traded options (“implied volatility,” or the market’s best guess about the chance of a big move in the stock price), some of the safest dividends are paid by the Chinese state-owned banks. That’s the market’s judgment, not a bank analyst’s.
Shown in the chart below is the option-implied volatility for China Construction Bank, the two biggest US banks (JP Morgan and Bank of America), as well as BBVA, the largest Spanish bank and BNP, the top French bank. China Construction Bank is the least volatile, that is, the safest of the group.
That wasn’t always the case.
Briefly in 2018 Chinese bank volatility went through the roof, when the chatter focused on a weak Chinese currency and capital outflows. China’s relative economic strength, though, has produced a strengthening currency, superior stock performance and strong capital inflows.
China Construction Bank, to be sure, is the strongest of the lot, at least in the market’s estimate. All the major Chinese banks hold reserves against loan losses in the range of 3% of the total, and there is no way to validate that estimate.
But the Chinese authorities have paid a rising dividend for the past ten years, and the political cost to the Chinese government of reducing this dividend by any substantial margin would be prohibitive.
This is the sort of stock one buys for income and tucks away in a drawer, so to speak. Price appreciation, if any, is a bonus. As it happens, the major Chinese banks are trading at low valuations, for example, a bit less than five times forward earnings in the case of China Construction Bank.
Here’s a conundrum: China Construction Bank has an implied volatility of 20%, compared to Bank of America’s 30%. Yet Bank of America trades at a forward price-earnings ratio of about 14 times earnings, versus. just five times earnings for China Construction Bank.
The market is saying that the Chinese bank is less risky, at least in terms of short-term price movement, but values its cash flows at a bit more than a third of BAC’s.
There are two ways to explain the conundrum. One is that global investors haven’t warmed to the idea of buying Chinese banks for long-term income, because they fear that something terrible might happen to China and Chinese banks sometime in the future.
China’s banks are heavily exposed to an overvalued property market, to be sure, and Chinese regulators are trying to cool it down.
There is certainly some risk of a mishap. In mid-2020, rumors flew that the Trump administration would issue an executive order banning the access of Chinese banks to dollar funding markets. That wasn’t going to happen because the blowback would be brutal, but it probably factored into Chinese bank stock prices.
The other explanation is that options traders in Hong Kong have a different view of the risk than do pension funds in Peoria. I won’t venture a guess as to which explanation is correct (they both could be correct).
Nonetheless, the Chinese banks stand up well in the standard models of portfolio risk-reward. I used the old-fashioned approach of optimizing a portfolio of dividend stocks to obtain the highest yield for the least portfolio volatility.
The computer chose the combination of stocks with the highest ratio of risk to return, that is, yield to price volatility. (Full disclosure: I own Chinese bank stocks.)
Some traditional income stocks such as utilities, telecoms and consumer staples are the portfolio favorites. I also gave the computer the choice of buying an Inverse VIX ETF (price goes up with the implied volatility of the S&P Index), and it allocated 11.5% of the portfolio to the edge.
But it also bought substantial amounts of China Construction Bank and Industrial and Commercial Bank of China stock (in the form of ADR’s). Otherwise, it bought small amounts of Public Storage, Pfizer and the Singapore country ETF.
The overall portfolio yield is 4.5%, and its volatility is 12% (compared to 20% volatility for the S&P 500). That doesn’t seem like a lot and it’s easy to increase yield by owning larger amounts of higher-dividend stocks.
But it compares well to less than 4% for junk bonds, which are subject to defaults, and it derives from companies with the pricing power to keep up with inflation over time.
No-one should invest on the basis of simple models like this one, to be sure, but it’s one more box on the risk-reward checklist. It suggests that in an income-deprived world, Chinese banks will have more sponsorship from global investors over time.