Foreign participation in China’s domestic bond market is accelerating, and the pace is likely to pick up even more during the second half of the year, ready for the proposed launch of the Bond Connect scheme by the end of 2017.
Moreover, the range of participants is broadening and a clear pattern is emerging in respect of the types of debt being traded.
Market participants believe China’s inclusion in more major bond indices, a stabilising renminbi/dollar exchange rate and the launch of Bond Connect will be the biggest growth drivers for a market where foreign investors are now starting to find their feet after the People’s Bank of China widened access to institutional investors in February last year.
Recent weeks have seen several moves that are proving to be game-changers for the world’s third largest market in terms of outstanding bonds: Rmb43.84 trillion ($6.36 trillion) at the end February.
In late February Beijing allowed foreign investors to use onshore derivatives to hedge their currency risk for the first time.
Then in early March Citi announced that Chinese government bonds were eligible for its regional and emerging-market indices. This came just a week after the launch of new Bloomberg Barclays benchmarks incorporating mainland debt.
Most recently, last Wednesday Prime Minister Li Keqiang announced that the Bond Connect scheme would launch by the end of the year. This, he said, will give overseas fund managers greater options for investing in China’s onshore bond market and help maintain Hong Kong’s position as an international financial centre.
Ken Hu, Invesco’s Asia-Pacific chief investment officer for fixed income, told AsianInvestor these factors mean there is no longer any reason for the index vendors not to include China. “We believe the onshore bond market will now be included faster than the domestic equities market.”
Hu added that index inclusion would help asset managers present a strong case to asset owners to expand their investment guidelines to include onshore bonds, although he thinks the process will take a few months.
He expects foreign investment flows to accelerate, boosted by the creation of more onshore exchange-traded funds. And these ETFs are also likely to come from big onshore players, said Barnaby Nelson, head of investors and intermediaries for Northeast Asia at Standard Chartered, one of the settlement agents for the China interbank bond market (CIBM).
Roughly 250 foreign institutions and banks are registered, or planning to use CIBM including 35 central banks, he told AsianInvestor. He noted that while some of the bigger central banks have been active for a while, it is the smaller central banks that are most enthusiastically entering the markets. This is because they are using China’s 10.29% weighting in the IMF’s special drawing rights basket to benchmark their foreign exchange holdings, he said.
Nelson added that most of the asset managers in the CIBM scheme comprise existing players with China exposure, but expects this to change soon.
“I’ve just come back from a series of meetings with asset managers in Korea, Taiwan and Malaysia,” he commented. “They’re bullish on the RMB and expect it to stabilise by the summer. This is when we should see the next wave of applications and new fund launches.”
Govvies all the way
Meanwhile, there is a clear pattern emerging in respect of the type of bonds foreign investors are purchasing.
According to figures cited by HSBC, the biggest jump has been in foreign holdings of Chinese government bonds and policy bank bonds (the latter are often more liquid than treasuries). Foreign ownership of such instruments rose 41.2% during 2016 to Rmb424 billion, or 3.9% of the total.
By contrast, overseas investors' overall RMB bond holdings stood at 1.7% at the end of February, or Rmb749 billion.
As Ivan Chung, head of Greater China research at rating agency Moody’s, explained: “Foreign investors aren’t moving down the credit curve. And even if they wanted to, there’s very little market-making in corporate bonds, as it’s still a buy-and-hold market.”
This is backed up by the experience of Insight Investment, a subsidiary of US financial services group BNY Mellon. Insight was the first foreign asset manager to register with the central bank for CIBM approval last year.
Portfolio manager Robert Simpson said Insight began trading the market last summer and has so far stuck to government bonds. “We’re not trading in and out every day,” he remarked. “We’ve treated it as a long-term allocation, although we have sold a little bit of paper.”
Simpson said Insight Investment found the four-day registration process extremely smooth and that it has been straightforward sourcing prices and placing trades with onshore brokers. He believes Bond Connect represents an important step for the market and could make a significant difference to trading volumes, since it will facilitate easier market access.
Whether Insight will use it remains to be seen. “We’re waiting to see the technical specifications and then we’ll decide,” he commented.
Many technical aspects are yet to be determined, but the scheme is likely be bookended by CIBM and the Shanghai Stock Exchange at one end and Hong Kong Exchanges & Clearing (HKEx) at the other.
However, there is a jurisdictional issue to resolve. Historically, equities have been cleared through HKEx’s Central Clearing and Settlement System, while bonds have been the purview of the Hong Kong Monetary Authority’s Central Moneymarkets Unit.
Benefits of Bond Connect
Moody’s Chung said there are a number of reasons why foreign investors would prefer to use Bond Connect from Hong Kong rather than register on the mainland. Firstly, they will be able to use their existing brokers and secondly they will not need a local custodian.
Thirdly, he argued that using Bond Connect means settlement risk will be lower because investors will fall under Hong Kong’s legal jurisdiction. An onshore custodian will technically hold all assets, but more crucially renminbi settlement will be conducted offshore within the framework of Hong Kong’s clearing system, which means there will be fewer concerns around capital controls.
However, Standard Chartered’s Nelson countered: “CIBM is a very robust system and there’s no kill switch, which foreign investors are often worried about.” He was making the point that Beijing would not impose capital controls on the CIBM at short notice, as has often happened in the equity markets.
Nelson concluded that that ultimately Bond Connect users fall under Chinese law in any event of default.