The newly-launched Bond Connect link between Hong Kong and mainland China is a game-changer, in our view, for global investors seeking access to high quality sovereign debt with attractive yields, such as that which China’s Interbank Bond Market (CIBM) can provide. The development may also accelerate the inclusion of China in major bond indices, which would have important implications for bond investors globally.
Before Bond Connect was unveiled in early July, overseas investors had to go through an onerous process of opening an account, applying for local currency quotas and finding an onshore clearing agent with international settlement capability. Now foreign investors can buy Chinese debt directly through Bond Connect thanks to mutual access arrangements for trading, custody and settlement.
The new link came just two days after the new Hong Kong leader, Carrie Lam, took office and pledged to be the bridge between Hong Kong and mainland China. China has already taken several important steps towards opening up the world’s third largest bond market to foreign investors (see Figure 1). These developments have increasingly put the renimbi (RMB) on a path towards becoming a major global currency.
What are the Main Benefits of Bond Connect?
Access to the China Interbank Bond Market (CIBM) has traditionally been limited to domestic and specialist players. It was only expanded to foreign investors in February last year, with conditions attached. Bond Connect, which now effectively displaces this type of access, takes things much further. It means the following for investors:
- No need for onshore settlement agent: instead of having to nominate an onshore settlement agent in order to be able to buy and settle bonds, investors can now trade directly with eligible dealers who are part of the China Foreign Exchange Trading System (CFETS). They can settle trades using a Central Moneymarkets Unit (CMU) sub-account via their global custodian or directly with a CMU member.
- A de facto end to investment quotas: Previously, Chinese bonds only could be bought via Qualified Foreign Institutional Investors (like State Street Global Advisors) and Renimbi Qualified Institutional Investors who were given investment quotas that prescribed the amount of the purchases investors could make. Now these quotas, in reality, will no longer apply.
- No requirement to retain onshore deposits: investors can now repatriate any surplus RMB to Hong Kong automatically on a daily basis.
- Offshore hedging: investors can now hedge currency risk using both onshore and offshore derivatives. Previously, hedging was only allowed with onshore instruments.
All these changes will make trading more efficient and documentation much simpler as there is no longer any need for a separate onshore account. They will also bring the following benefits for market participants:
- Ability to trade electronically: allows for improved price discovery directly with CFETS dealers, improved liquidity and executable size.
- Risk management: able to use offshore Chinese Government Bond futures and Non-Deliverable Interest Rate Swaps to manage interest rate risk, as well as CNH (offshore yuan) futures and forwards for currency risk.1
- Operational convenience: provides easy application and setup, with familiar international trading interfaces, use of offshore custodians and wide intermediary access via CMU members.
How Have Investors Reacted So Far?
Investors’ initial response to the Bond Connect has been very positive. Around 70 offshore investors participated in the first day of trading. They recorded 142 transactions, which amounted to RMB7.05bn (US$1.04bn).
Government bonds were the mostly actively traded, followed by policy banks’ bonds. This is in line with our expectations as the two sectors represent the most liquid parts of the CIBM. They have consistently traded on a 2-3 basis point bid/offer spread.
Nearly 80% of the trades were settled on a T+2 basis, which is the lengthened settlement cycle introduced to facilitate transactions by international investors. There were also two bond auctions conducted through Bond Connect in the first week, held by the policy banks Agricultural Development Bank of China and China Development Bank.
What Happens Next?
Given the opportunity that Bond Connect presents for international investors to access the CIBM more easily, we expect it to become the preferred route. Foreign investors currently own less than 2% of the $9.4 trillion2 Chinese bond market (see Figure 2).
But since 2016, China has been on a deliberate policy path to open up its financial markets to overseas investors. This latest move is likely to accelerate the acceptance of China into the mainstream of fixed income. And once major index providers decide to add the country to emerging market or even global indices, investors will be obliged to allocate a significant proportion of their portfolios to Chinese bonds; with this new access link, that day is getting closer. It is therefore prudent for investors to consider whether they or their investment manager are prepared for such an eventuality. At SSGA, we have been investing in the CIBM for over a decade and are ready to assist our clients with managing this change.
2Source: Nomura Holdings
IMF: International Monetary Fund is a global body created to coordinate exchange rates and financial relations around the planet with the general aim of promoting stability.
SDR: Special Drawing Rights are supplementary foreign-exchange reserve assets defined and maintained by the IMF.
FX: Foreign Exchange is the market where world currencies are traded.
The views expressed in this material are the views of David Furey through the period ended 7/21/2017 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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