China may have been wrestling with ongoing trade tensions and an economic slowdown, but the country’s domestic bonds continue to attract global institutional investors such as central banks, which are increasing their renminbi-denominated assets.
The country’s local renminbi (RMB) bonds are now set to truly move into the mainstream, following today’s (April 1) introduction of domestic Chinese government and policy bank securities to the Bloomberg Barclays Global Aggregate Index. A Bloomberg release said the index would include 363 Chinese securities, and that they will collectively account for 6.03% of the $54.07 trillion index upon the completion of a 20-month phase-in.
The inclusion will mean investors using the index as their benchmark are required to invest into renminbi bonds, increasing the inflows of capital and causing more fund houses and asset owners to try to better understand China’s bond market.
It’s a positive move. But investors still face many challenges to fully access the market. What can the Chinese authorities do to ease regulatory hurdles for foreign investors to tap opportunities in domestic bonds? And what weighting of these assets should investors build?
AsianInvestor asked five investment specialists to share their thoughts.
The following extracts have been edited for brevity and clarity.
Edmund Goh, Asian fixed income investment manager
Aberdeen Standard Investments
We think the first and foremost [step Beijing should take] is to make investing and hedging in the China market cheap. Introducing easy and low-cost hedging methods (e.g. onshore USD/CNY hedging), opening up Chinese government bond futures to foreign funds, and a firm tax waiver, as opposed to temporary tax relief, would all be good news for foreign investors.
Easy access, attractive risk characteristics and effective hedging tools are key to removing obstacles for China’s further inclusion into global bond indices, as index providers take into account feedback from their international users. Compatibility of system support and legal agreements for foreigner investors would also speed things up.
With the relatively attractive yield, low correlation to global markets and stability of the renminbi, we believe onshore China bonds can potentially offer attractive returns and a way to diversify portfolio risk. Whether or not China is included in global indices, the RMB bond market is worth exploring.
We think investors should keep at least benchmark weighting even if they don’t like the duration risk in China. The yield of China bonds is attractive at the moment relative to other global bond markets.
Investors need to approach the market with caution and do their homework. Potential risks include understanding liquidity risk and credit risk, insufficient hedging options and an immature legal process for handling default and recovery.
For now, the rates market is more suitable for foreign investors. For those who want to venture into high yield renminbi credit onshore, significantly more headcounts on the ground in China would be required so as to effectively manage credit risks.
Karan Talwar, senior investment specialist, emerging market fixed income
BNP Paribas Asset Management
The Chinese authorities have taken considerable steps in recent years to open up the financial markets to foreign investors. While enhancements around market access can continue to improve, key operational hurdles have now been removed, making it easier for foreign investors and international indices to include onshore Chinese bonds.
Some aspects of the market will also improve as the market structure changes. For example, increasing the share of foreign ownership should help with market liquidity. Having credit ratings available from the leading international credit rating agencies will also provide foreign investors with more transparency.
Outside of the operational aspects, there are key investment factors to consider. The macro environment continues to remain supportive to warrant investment into onshore government bonds, with slowing growth and benign inflation likely to cause further selective rate cuts by a broadly dovish People’s Bank of China.
The technicals also remain favourable, with foreign investors demand likely to rise as onshore government bonds continue being added to mainstream international bond indices.
That said, the yield curve is quite flat and long term inflation expectations may rise as more reflationary policies are initiated to stabilise growth. Local government bond supply may also rise to support higher infrastructure spending. So we prefer to invest in shorter maturity bonds and also like selective policy bank bonds.
Other risks include the fact investors can no longer assume the government will bail-out overly indebted companies, especially those in less strategically important sectors, and indeed default levels rose in 2017 and early 2018 before policy makers started easing onshore credit conditions.
Finally, if investors buying Chinese bonds on an unhedged basis could be subject to volatile foreign exchange moves – especially as the renminbi has become a more free-floating currency.
Gregory Suen, investment director, fixed income
HSBC Global Asset Management
We think the Chinese authorities have already taken many of the important steps to be considered for the major global indexes. The most important was introducing more and improved access routes for the onshore bond market, including the China Interbank Bond Markets (CIBM) Direct and Bond Connect schemes. These have made it much easier for foreign investors to access the market.
The authorities have also proactively tackled various issues in order to suit foreign investors’ needs, such as clarifying on tax treatment and allowing block trades.
Looking ahead, other index providers may need some time to ensure the overall process is working smoothly. Additionally, the current index inclusion only involves government bonds and policy bank bonds. Trading in these is extremely liquid, but onshore corporate bond liquidity may need to be enhanced before they are included in global indexes.
We suggest investors hold at least a market weight for the onshore RMB bond market. Coupon carry is a very important part of the total return for fixed income investment and Chinese bonds offer higher yields compared to other major bond markets within the Bloomberg Barclays Global Aggregate Index. For example, the 10-year China Government Bond yields around 3.1%, while the 10-year US Treasury and 10-year French government bond are around 2.4% and 0.3%, respectively. And some markets offer negative yields.
This is also supported by our current constructive market view on RMB bonds, as macro fundamentals of a slowing domestic economy, benign inflation and ample onshore liquidity should support the Chinese bond market.
Finally, because the Chinese bond market has very low correlation with most other global bond markets, it is very difficult to efficiently replace the exposure within the portfolio. Such unique correlation characteristics make China an effective diversification and risk management tool in a global portfolio.
Claudia Calich, fund manager
The introduction of schemes such as the Renminbi Qualified Foreign Institutional Investor Scheme (RQFII – introduced in 2011) and more recently the creation of the Bond Connect programme in July 2017 led to the inclusion of Chinese renminbi-denominated government and policy bank securities to the Bloomberg Barclays Global Aggregate Index.
Both initiatives facilitate access for foreign investors to the CIBM by relaxing restrictions where before quite strict quotas were in place. Though some operational challenges remain, these market-opening initiatives have encouraged index providers to shift their attention to Chinese bonds.
This will depend on one’s assessment of the Renminbi and core rates in China. Chinese government bonds seem fairly attractive from a risk-reward perspective in today’s yield-deprived sovereign bond world. Their relatively low correlation with other bonds in the Bloomberg Barclays Global Aggregate index could offer investors good opportunities for diversification.
However, as the capital account opens further for foreign investors, I will expect those correlations to change, particularly as more participation by foreign investors makes capital flows more volatile, which could increase the volatility of asset prices.
Operational challenges include deciding on what is the best way to access the Chinese market: through onshore access, which is traded in renminbi but more subject to quotas and regulation, or through the offshore vehicle such as Bond Connect, which has less regulation but will expose the investor to a basis risk between the onshore and offshore renminbi.
Other issues include transparency of trading costs, tax regulation, availability of derivatives hedging and repatriation of assets in the case of onshore exposure. Many investors will also look for further developments in areas such as corporate governance and data integrity from the country’s markets.
Arthur Lau, co-head of emerging markets fixed income and head of Asia ex-Japan fixed income
Aside from index inclusion, Chinese authorities can continue to work on the infrastructure, market accessibility and information disclosures to facilitate further development of foreign participation, particularly in the onshore corporate bond markets. Moreover, adhering to a credible and internationally recognised credit rating system is critical to gaining foreign investors' participation in the onshore corporate bond market.
In addition, more transparent and standardised financial disclosure practices, along with creditor-friendly liquidation and bankruptcy frameworks, would help advance non-government Chinese bonds to the global arena. It’s also necessary to further strengthen and develop the onshore derivative markets to provide effective and efficient tools for hedging purposes.
While there is a three-year tax exemption on investment in the onshore government bonds, it would be extremely useful if the Chinese authorities have a longer-term framework on tax issues that meaningfully help foreign investors make structural investment allocations to onshore bond markets.
The amount of exposure that investors gain to RMB bonds really depends on their individual investment profiles, objectives and risk appetite. That being said, we believe the Chinese bond markets are important enough that investors should structurally, not tactically, allocate assets into the onshore bond markets.
As such, they should have neutral positions in Chinese bonds against their respective benchmarks. And given some liquidity and concentration issues, we think investors should phase in their asset allocations into the Chinese markets.
Aside from information disclosures, liquidity and capacity and availability of various hedging tools are yet to improve. For medium to longer term, it’s essential for China to ensure credible credit rating and creditor-friendly bankruptcy systems. Moreover, a clear framework about the protection of property rights along with transparent and reliable asset recovery processes and procedures are areas that pose risks for investors.