After a difficult 2018, Chinese markets are on the cusp of the Chinese New Year – ushering in the Year of the Pig, an animal that represents luck, wealth, honesty and prosperity. While the country faces headwinds from its de-leveraging process and the trade dispute with the US, we see several reasons for investors to consider Chinese government bonds, not least their upcoming inclusion in major global indices – the first of which has been confirmed today and will start in April. Given the likely impact of that inclusion (the Chinese bond market is the third largest in the world) and the challenges it could present, it is important for all global bond investors to be well prepared and check they have the right market access in place.
Chinese Bonds Offer Diversification
In an environment still dominated by low sovereign bond yields, investors seeking diversification need to look beyond their home markets to unearth attractive yielding assets with low correlations to their core portfolio exposures. Despite the yield compression in 2018, China government bonds still offer yields of around 2% above those of global treasury bonds. Given its still-small foreign investor base, the Chinese bond market has a very low correlation with global bond markets – just 0.2 versus US Treasuries over the past decade. While that is set to change as Chinese bonds become more readily available to overseas investors, we believe they are likely to be well supported by easing policy measures as well as by inflows associated with the index inclusions.
China Bond Index Inclusion – Expected Timing and Potential Impact
Since early 2016, China has been on a deliberate policy path to open up its financial markets to foreign institutional investors, as part of a broader strategy to shift global influence and power towards the East. The reforms introduced as a result have accelerated the case for the acceptance of China into mainstream bond indices. Bloomberg Barclays confirmed today that China treasury and policy bank bonds will be included in the widely followed Bloomberg Barclays Global Aggregate Bond Index from April 2019. JP Morgan, meanwhile, continues to evaluate the inclusion of China treasury bonds in its flagship local currency emerging market index, the JPM GBI-EM Global Diversified Index. This will have a significant impact on the indices as they currently stand.
In our blog “China Debt Inclusion in Global Agg Extends Historic Opening of Markets” published in April 2018, we highlighted three key areas which needed clarification prior to index inclusion:
1. Implementation of delivery-versus-payment (DVP) settlement
2. Block trading under Bond Connect
3. Taxation policy
All these boxes have now been ticked. DVP and block trading is permitted while a full tax exemption for overseas institutional investors in the China bond market has been declared for three years until November 2021. Now that one major index has included the bonds, it is likely that the other will follow. If onshore Chinese bonds are added to all fixed income indices, there is scope for approximately USD 420 billion1 of inflows, potentially having a significant impact on the securities already in the index as well as those that are being added.
Access to China’s Onshore Bond Market – Requirements, Timelines and Investor Readiness
To prepare for the upcoming index inclusion, foreign investors need to gain access to onshore Chinese bond markets. Currently there are four major access routes: QFII, RQFII, China Interbank Bond Market (CIBM) Direct and Bond Connect. International investors new to China are likely to use the latter two options as they offer faster, quota-free access to the onshore bond market. Chinese regulators are also working towards equal market and instrument access for both CIBM Direct and Bond Connect schemes, so both offer similar treatment in areas such as: quotas (free), eligible investors, investment scope, settlement cycle (T+0/T+1/T+2), settlement method and taxation.
While the Bond Connect route appears to be quicker – for example, it does not require the appointment of an onshore settlement agent bank and has a faster stated registration timeline – the documentation and process are in fact similar in complexity to that of CIBM Direct. The actual registration time for both is around 6 months on average.
So when Chinese bonds are included in April this year, investors without these schemes in place will need to find external entities which are ready to access the market or they may find themselves at a disadvantage. If you have investments in major global bond indices, it is worth checking with your manager and custodian as to whether they are operationally ready for this index shift or whether you need to go elsewhere.
As of November 2018, there were almost 400 foreign entities registered under the CIBM scheme, compared to just 300 in February 2017, and over 260 registered for Bond Connect. Of those who are registered but not central banks, at least a third are asset managers. Some are overseas arms of Chinese firms, Hong Kong companies and Asian (particularly HK-based) branches of international players. Also, some investors have entered both schemes using different subsidiaries or funds within the same group to leverage the comparative advantages of each.
Nonetheless, bond holdings by foreign investors are still relatively low as many continue to wait and see how the market will develop. Setting aside recent market drivers such as China bond yield compression, RMB volatility and the trade war, we believe there are areas where the market structure needs to continue to evolve to encourage overseas investors to trade in Chinese bonds.
These include ensuring that global custodians have sufficient time and capability to handle foreign exchange trading and settlement for the CIBM and Bond Connect, simplifying the Bond Connect registration process, expanding limited hedging options and gaining permission from external regulators such as Ireland to access the onshore Chinese market via domestic funds. Any progress made in these areas by both the Chinese authorities, overseas regulators and market participants could help smooth the inclusion of Chinese bonds into the major indices. It is also worth noting that Chinese credit has yet to be included, so further progress needs to be made in this sector.
Why Use an Index?
There is a common perception that the best approach to investing in emerging markets is an active one in order to take advantage of anomalies created by illiquidity, sector concentration and a lack of transparency. However, over the past decade, these markets have changed and certain sectors have become far easier to trade, facilitating their inclusion into the major bond indices. For example, onshore China treasury and policy bank bonds, which represent the most liquid portion of CIBM with an international rating of A+, will be the first to be included in the Barclays and potentially the JP Morgan indices.
This may limit opportunities for active managers to add significant value in this particular sector, while the number of liquid index members should be sufficient to employ an effective sampling approach when building an index portfolio. Indexing costs can also be minimized through a reduction in turnover, primary market participation and through capitalizing on market inefficiencies between on-the run and off-the run bonds.
Extensive Experience in the Chinese Bond Market
State Street Global Advisors has already completed all the necessary operational requirements to manage China bond and FX exposures for our client portfolios. We expect the CIBM to be the more liquid and efficient access route for bonds, given the dominance of domestic investors there. So, as these index announcements happen, we are well positioned to add Chinese exposures to our client portfolios in the most effective way.
We have been managing and trading onshore China bonds2 since 2005. This has enabled us to develop long-term relationships with Chinese regulators, official institutions and local investors, giving us deep insights into how the markets operate and allowing us to establish robust trading strategies for our clients.
Our Asian branch began with access to the CIBM, operating with quota constraints, and in 2018 registered to use Bond Connect. Our London office has now submitted registration applications for CIBM and Bond Connect, which will give us global reach in terms of being able to trade Chinese bonds. We continue to keep a close eye on market developments so we can be among the first to take advantage of more open, transparent and liquid trading systems around the world, and particularly in hugely important markets such as China.
1 Quoted from “All Eyes on China” published on November 26, 2018 under SSGA GMO 2019. Source: State Street Global Advisors estimates using the Barclays Global Aggregate, JP Morgan GBI-EM and FTSE Russell World indices and based on the assumption that active managers will buy stocks in anticipation of index flows.
2 As of December 2018, SSGA managed around US$870million onshore China bonds under Pan Asia Bond Strategy.
The views expressed in this material are the views of Bruce Zhang and David Furey through the period ended 01/31/2019 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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