Holdings of US agency debt may rise further

FX reserves to lead to higher returns, greater diversification and reduced risk

China's holdings of debt issued by U.S. government-sponsored agencies may continue to rise, a trend that can help China's foreign exchange reserves gain higher returns and greater diversification, analysts said on Monday.

According to data from the U.S. Department of the Treasury, China's holdings of U.S. agency bonds — bonds issued by U.S. government-sponsored agencies like mortgage buyer Freddie Mac — stood at $259.99 billion as of January, up by $55.3 billion, or 27 percent, from a year ago.

The increase has bucked the downtrend in China's holdings of U.S. Treasuries, besides sparking discussions as to why China has boosted exposure to U.S. agency bonds that are deemed quasi-government assets while selling U.S. government assets.

China's holdings of U.S. Treasury securities, including Treasury bills and longer-dated Treasury bonds and notes, have slid for six consecutive months to $859.4 billion as of January, down by $174.4 billion year-on-year, showed data from the U.S. Department of the Treasury.

Experts said a key driver of China's rising holdings of U.S. agency debt was its higher yield over U.S. Treasuries.

A recent Bloomberg report said that the U.S. agency bonds' yield premium over U.S. Treasuries has widened over the past year, with the option-adjusted spread between U.S. agency bonds and Treasuries increasing to about 28 basis points as of mid-February, up from about 15 basis points a year ago.

Han Tan, a market analyst at financial trading platform FXTM, said China's increased holdings of U.S. agency bonds appear to be intended to capture their higher yields over U.S. Treasuries.

"Greater exposure to U.S. agency bonds generates higher interest income as well as greater diversification, so as to support policymakers' risk management objectives," he said.

China's increased holdings of U.S. agency bonds seem to be part of the country's broader efforts to diversify reserve assets.

For instance, China's gold reserves have risen to 66.5 million ounces at the end of March, equivalent to $131.65 billion and up from 65.92 million ounces in February, marking the fifth consecutive month of increase, according to the State Administration of Foreign Exchange.

Hong Hao, chief economist at GROW Investment Group, said he expects China may further increase holdings of U.S. agency bonds, which are considered as good as government credit with very limited default risks.

"As these (U.S. agency) bonds have proved their creditworthiness time and time again and are considered close to risk-free, it pays to hold them for their higher yield," Hong said.

Despite the potential for China to buy more U.S. agency debt, analysts said it is still unlikely for China to significantly increase exposure to U.S. government debt and quasi-government debt as a whole due to security considerations.

China's foreign exchange reserves increased to $3.1839 trillion by the end of March, up by $50.7 billion, or 1.62 percent, compared with the end of February, SAFE said.

To ensure safety of China's foreign exchange reserves, it may become necessary for China to reduce holdings of U.S. debt, given lingering geopolitical tensions and the U.S. government's elevated level of debt, said Yang Haiping, a researcher at the Central University of Finance and Economics' Institute of Securities and Futures.

While China's holdings of U.S. agency debt increased over the past year, the country's total holdings of U.S. long-term securities have decreased to $1.42 trillion as of January, down by $111.48 billion year-on-year, according to U.S. Department of the Treasury.