Index debut to boost Chinese onshore bond inflows | Fixed Income

They may be coming off a low base but fast-growing foreign capital inflows into onshore Chinese bond markets look set to get an important leg-up from their inclusion for the first time in a widely tracked global debt benchmark.

Bloomberg, one of three flagship local currency bond index providers, last week became the first to announce that it would be adding Chinese renminbi-denominated government and policy bank bonds to its Bloomberg Barclays Global Aggregate Index.

The move, to be phased in over a 20-month period starting in April 2019, is inevitably expected to have the most immediate impact on passive bond funds tracking the index.

“We ... roughly estimate passive inflows into China as a result of this index inclusion to be around $75 to $100 billion,” Karan Talwar, emerging markets fixed income investment specialist at BNP Paribas Asset Management, said.

“We expect the other two indices, the JP Morgan GBI-EM and FTSE Russell WGBI indices, to follow suit in due course,” he added, potentially raising the total amount of onshore Chinese assets managed against these indices to as much $300 billion.

The Bloomberg index is a measure of global investment grade debt from 24 local currency markets. Once China gets to its full weighting, Chinese renminbi bonds will provide the index's fourth-largest currency component, after the US dollar, euro, and yen, Steve Berkley, global head of Bloomberg indices, said.

“Using data as of January 31, 2018, the index would include 386 Chinese securities and represent 5.49% of a $53.73 trillion index,” he told AsianInvestor.

LITTLE ACORN

At present, foreign investor participation in the Chinese bond market is quite low, Tuan Huynh, chief investment officer and head of discretionary portfolio management at Deutsche Bank Wealth Management, told AsianInvestor.

“Foreigners still hold less than 2% of China’s domestic bond market. In comparison, foreigners hold 11% of Japan’s bond market,” he said.

However, foreign investor interest is growing fast, Huynh said, with net foreign purchases of renminbi bonds surging by 41% year-on-year in 2017 to Rmb346 billion ($55 billion).

“Foreigners are getting more interested in China’s renminbi-denominated bonds recently because of its higher interest rate and the stabilisation of the renminbi[-dollar] exchange rate,” he said.

Chinese three-year government bonds were yielding 3.53% as of March 26, compared with US Treasuries and Japanese government bonds of the same tenure, which yielded 2.36% and -0.14%, respectively.

“We expect more foreign investors to invest in the onshore Chinese bond market, which currently is predominantly owned by domestic investors,” Talwar said.

PENDING ISSUES

There are still some issues with delivery versus payment and tax clarification, Andy Seaman, chief investment officer of Stratton Street, said, but otherwise he believes the inclusion is warranted. “[The bond market] is liquid, you can access it, and these days you don’t even need to apply for a quota,” he told AsianInvestor.

Delivery versus payment, which ensures that buyers get delivery of the bond at the same time as they make the payment, and tax clarification issues are also top of mind for the index provider, and inclusion is conditional on the PBoC and the Chinese ministry of finance implementing operational processes that address these concerns.

Taxation issues can be particularly complicated, Frank Lee, senior investment strategist in the consumer banking group and wealth management at DBS Bank, said, especially in regards to how Chinese authorities differentiate between foreign and domestic entities.

“How do you classify overseas money, or how do you classify the corporate that invests in these kinds of fixed income? How do you classify the identity of the investors?” Lee told AsianInvestor.

Lee expects these issues to be cleared up by April 2019 but he foresees some volatility in Chinese non-government and non-policy bank bonds between now and next April. “Before this deadline, the market will fluctuate and be quite volatile because of a lot of reforms and policies that will be implemented,” he said.

OPENING UP

The decision by Bloomberg to include Chinese bonds in its index is also reflective of a wider trend in which markets are opening up across the Chinese asset classes, Lee said.

“We had equities, right now it is fixed income, and [earlier this week] it was commodity futures,” he said.

In June 2017, MSCI announced that it would include China A shares in its emerging markets index starting in June 2018, while renminbi-denominated oil futures began trading on Monday.

“Chinese policy makers have made significant strides to open up their capital markets over the past few years and MSCI’s decision to include China A shares earlier last year and Bloomberg’s recent announcement are a testament to these efforts,” BNP Paribas’ Talwar said.

The inclusion could, in turn, lead to further improvements in the Chinese financial system, according to Deutsche’s Huynh.

“More foreign participation may improve the transparency level of China’s bond market and support the internationalisation of the renminbi,” he said.