Foreign buying builds China bond index inclusion case

Foreign investment capital has surged into Chinese domestic bonds over the past year, intensifying pressure for the inclusion of China’s $9.3tn bond market in dominant market indices that direct some of the world’s biggest fund flows, fund managers and analysts said.

A year since China took meaningful steps to further open its bond market to international capital, inflows from foreign institutions rose 53 per cent to Rmb732bn ($155bn) at the end of February this year, according to data from Haitong Securities, a Chinese brokerage.

This rising popularity, coupled with significant market reforms by Beijing and the recent approval for China to join some international bond market indices are strengthening the case for inclusion in dominant benchmark indices, analysts said.

“Global and emerging markets investors are likely to have to build up to a five to 10 per cent holding in Chinese domestic bond markets over the next three to five years,” said Miranda Carr, senior analyst at Haitong Securities UK. Foreign investors currently account for just 2 per cent of holdings in domestic Chinese bonds.

“We are likely to see up to $250bn committed to China’s domestic bond market by foreign investors over the next three to five years,” she added.

Tang Xiaodong, chief executive of China AMC, a leading Chinese fund that managed $602bn at the end of last year, said China’s recent entry in bond sub-indices was leading to an upsurge in interest from large financial institutions in the west including sovereign wealth funds, insurance companies and pension funds.

“This is a big deal,” Mr Tang said. “(Benchmark inclusion) would force everyone to invest into China’s bond market.”

Fund managers measure their performance against a variety of different indices but only a few widely-followed indices dominate the market to the extent that should Chinese bonds be given a weighting in them, funds would need to boost their holdings to reflect that weighting.

Thus, a decision this month by Citigroup, a US investment bank, to include Chinese domestic bonds in three sub-indices may boost interest but will not compel buying activity. So far, Citigroup has withheld approval for China’s entry into its dominant World Government Bond Index (WGBI), which had a market value of $19.9tn at the end of February.

By contrast, the following for the three sub-indices that are set to include onshore Chinese bonds — the Emerging Markets Government Bond Index (EMGBI), Asian Government Bond Index (AGBI) and the Asia Pacific Government Bond Index (APGBI) — does not amount to more than a “few billion dollars”, analysts said.

Bloomberg Barclays said this year that it would create new variants of its dominant benchmarks to include China bonds, while keeping the original benchmarks unchanged. Thus, the new Global Aggregate + China Index and the Emerging Market Local Currency Government + China Index will give investors the option of including Chinese bonds in their portfolios — but not oblige them to do so.

The JPMorgan GBI-EM index, a benchmark for emerging markets bonds, has given no indication it intends to include China in the index. It sees technical and market issues that have yet to be cleared up, though its monthly review gives it the flexibility to move swiftly if its concerns are resolved.

Given that China is expected to take a 10 per cent weighting in the JPMorgan GBI-EM index, which is tracked by about $210bn in funds, any China inclusion would trigger roughly $20bn in inflows, industry analysts said.

Index considerations aside, Mr Tang said an existing powerful draw for investors was the 3.4 per cent yield on Chinese government bonds. By contrast, the value of negative yielding sovereign and corporate bonds around the world climbed to $10.5tn on March 7, up from $9.8tn on February 21, according to Tradeweb, a financial services company.

So far, those institutions which have boosted their investments in Chinese bonds since the opening last February have adopted a conservative philosophy. Both foreign banks and institutions have shown a marked preference for Treasury bonds and policy banks, such as the China Development Bank and Export-Import Bank of China.

While foreign investors’ holdings account for more than 5 per cent of total Treasury bonds in China, the appetite for corporate bonds has been much more subdued. This reluctance stems from uncertainties over transparency and the very high debt levels that blight many state-owned companies and some of their private counterparts.

The conservative stance also derives from the fact that most of the foreign institutions that have been allowed access to China’s bond market have been central banks and supranational organisations that need renminbi exposure but are less interested in trading the market.

Beijing, though, is starting to target more nimble investors too. Li Keqiang, China’s premier, said this month that China plans to introduce this year a bond trading link between Hong Kong and the mainland called “Bond Connect”. Importantly, the new programme will not require international investors to open accounts onshore but rather allow them to trade mainland bonds from their Hong Kong accounts.

.