The wall of money heading to Chinese bonds
China’s domestic, renminbi (RMB) denominated, bond market has expanded rapidly over the past decade. In 2008, total RMB bonds were equivalent to just short of 50% of nominal Chinese GDP. By 2018 this figure had increased to 95% and China’s domestic bond market is now the third largest in the world, behind the US and Japan, with a total value of close to $12.3 trillion, as at the end of Q2 2018.
Chart 2 below highlights the extent of the growth in Chinese RMB bonds as a share of the total global bond market. In 2002, Chinese RMB bonds' share was just 0.9%. By 2018 this had risen to around 11%, as evidenced by data from the Bank of International Settlements. Yet China had no representation in any of the major global bond indices until the start of April this year.
Index inclusion underway
The inclusion of Chinese RMB government bonds in the Bloomberg Barclays Global Aggregate Index began at the start of April. This is one of the most widely followed global bond indices, with $2.5 trillion of funds tracking the benchmark index, as at December 2018.
The process of inclusion will be phased over 20 months, with a final index allocation weight of 6% to Chinese bonds. And there is room for this share to increase, given that this is only half of China’s overall global bond market share.
Other index providers are also considering the inclusion of Chinese onshore government bonds. This includes the FTSE World Government Bond Index and JP Morgan GBI-EM indices.
Foreign investor inflows
For most tracker or index funds, their mandates will require them to invest in onshore RMB bonds following index inclusion. Meanwhile actively managed funds would also have to invest in RMB bonds, or open a risk position by being underweight to their benchmarks.
At current prices the Bloomberg Barclays Global Aggregate Index inclusion alone is likely to attract inflows of around $151 billion. As the table below shows, further inflows could potentially follow if other index providers follow suit and include Chinese onshore bonds.
An attractive investment opportunity: it is not just an index flow story
In general, Chinese onshore government bonds have provided very attractive return opportunities in most major currencies, as the chart below highlights.
In terms of volatility, onshore Chinese bonds tend to experience relatively modest levels of volatility and when the volatility is adjusted for their returns, historical data suggests that Chinese government bonds offer an attractive investment opportunity.
Other factors to consider
The RMB bond market is varied and inefficient, which in our view increases the scope for active fund managers to generate above market returns. There are opportunities across both the government and non-government bond sectors. The non-government sector is unusually larger than the pure government bond sector, and offers credit spread opportunities.
The coverage of international credit rating agencies within the Chinese RMB bond market is narrower than seen in other global bond markets. This raises the prospect for active fund managers to exploit ratings arbitrage opportunities. It is important that investors understand the nuances of the RMB bond market. In particular the issuing entities’ capital structures, local bankruptcy laws and Chinese accounting standards. In our view, having a strong grasp of these factors is key to identifying inconsistencies in fundamentals of issuers relative to their ratings.
Furthermore, Chinese government bonds have a very low correlation relative to other government bonds markets. As a result, their addition to a global bond portfolio can provide attractive diversification benefits.
Access to Chinese onshore bond market continues to improve
Investing in Chinese onshore bonds is not a seamless process, as the Chinese government employs capital controls for domestic investors resulting in tight control of capital flows into and out of the country. However, the authorities have taken, and continue to take measures to improve access for foreign investors in the last ten years. The inclusion of Chinese onshore bonds (and ongoing inclusion of some onshore A share equities, which began last year) is illustrative of China’s increasing integration with global financial markets.
Foreign investors can invest through several schemes to access the onshore bond market. These are the QFII (Qualified Foreign Institutional Investor), RQFII (RMB Qualified Foreign Institutional Investor), CIBM Direct (China Interbank Bond Market) and Bond Connect (a scheme launched by the Hong Kong Exchange).
Each scheme has its advantages and disadvantages and understanding which to use to access the onshore bond market is a function of the type of investor wanting to access the market and which part of the market that the investor wants to access.
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