Institutional investors are gearing up to buy into the Chinese government bond market as more global indices are adding these bonds, SSGA says.
From October this year, Chinese bonds will gradually be included in the FTSE World Government Bond Index (WGBI) over a period of 36 months, paving the way for large institutional inflows into this market.
Although onshore Chinese bonds have been included in other indices before, the inclusion in the WGBI is expected to attract more than $175 billion in institutional inflows.
Globally, the index is commonly used for global sovereign allocations and this is also the case in Australia, particularly where investors have separated investment-grade credit and sovereign bond allocations within their fixed interest portfolios.
Kheng Siang Ng, Head of Fixed Income for APAC at State Street Global Advisors, likens the inclusion of Chinese onshore bonds in more broad global indices to the launch of the euro in 1999.
“If you look back to around 2000, we had the creation of the euro and that was a big bang, so to speak. But since then the financial markets have gone through the global financial crisis in ‘07-’08 and we haven’t had much of a major development in terms of structural market change,” Ng says in an interview with [i3] Insights.
“But the next major development is the Chinese bond inclusion. This is a very important milestone for the fixed income markets.”
If you look back to around 2000, we had the creation of the euro and that was a big bang, so to speak. But since then the financial markets have gone through the global financial crisis in ‘07-’08 and we haven’t had much of a major development in terms of structural market change. But the next major development is the Chinese bond inclusion. This is a very important milestone for the fixed income markets
What makes the inclusion unusual is the sheer size and quality of the Chinese market. As of March this year, the market for Chinese local currency government, central bank and other government bonds stood at Y10 trillion (A$2 trillion), according to the Asian Development Bank.
The market has seen rapid growth in recent years, as it was only half its current size in 2017.
“For the very first time, we see [the inclusion of] a market that is the second largest bond market in the world,” Ng says.
“In the past, when a bond market was included into any major index, they were very small. For example, when Malaysia was added, it only added 0.2 to 0.3 per cent to the index. But China will be 5 to 6 per cent of the index.
“More recently, we had Serbia included in some of the global emerging markets and our London team was really busy with that. But rarely do we see a market being included in such a big way. That’s why I’ve likened it to a major development, such as the launch of the euro.”
Unlike other emerging markets, China also is less risky from a credit-rating perspective, Ng says, which makes an allocation to these bonds even more attractive.
“China is not like a fully fledged emerging market, so to speak, in terms of high risk. Typically, we have markets included that are really higher risk in terms of credit rating, but now we are getting a country with a single A [rating], so that is rare as well,” he says.
Accessing the Market
Unlike with Chinese domestic equities, investors do not have to apply for a QFII licence to invest in onshore bonds. There are no quotas. This means we could see rapid adoption of Chinese bonds in institutional portfolios.
“People often say that the capital account for China is closed, right? But for the bond market it is completely open. Bring in as much as you want,” Ng says.
“It is important to note that China has opened up one aspect of its capital market. You’re not seeing that in stocks. With stocks there is a bit of a gate; there’s a limit on FDI (foreign direct investment).”
Since there are no quotas, repatriation of funds is also less of a concern in the bond space, he says.
“The capital account for bond investments is fully open, so that statement means that there is no repatriation issue. You can repatriate as much as you have,” he says.
The capital account for bond investments is fully open, so that statement means that there is no repatriation issue. You can repatriate as much as you have
“But there are certain rules around currency denomination when repatriating. If you bring in money through US dollars, you can only bring out money in US dollars. They are trying to minimise arbitrage.
“If you bring in different currency mixes, then they have a certain ratio that they want you to observe so that there isn’t any arbitrage.”
There are two main ways of accessing the onshore market. One is directly, through the China Interbank Bond Market (CIBM), which was established in 2016. This scheme is predominantly used by domestic investors and requires an on-the-ground presence and certain permits.
Or indirectly, through the Hong Kong Bond Connect program. “This process is slightly simpler because it is using mainly global custodians and it lessens the amount of account opening documents,” Ng says.
The Bond Connect program was launched in 2017 and since then the share of government bonds held by foreign investors has grown from 4 per cent to nearly 10 per cent now.
Chinese Bonds in Portfolios
One of the key reasons to invest in Chinese bonds is yield. Whereas most 10-year developed market government bonds yield less than 1 per cent, the Chinese 10-year bond stood at around 3 per cent at the time of writing, a nice pick-up in a yield-starved world.
But from a portfolio construction perspective, one of the most attractive characteristics of Chinese onshore bonds is diversification. Because this is still a market largely dominated by local investors, it behaves differently from developed markets, but also from most other emerging markets, Ng says.
“You get a diversification benefit because this market is fairly new to foreign investors,” he says.
“If you break down the Chinese government bond market, then foreigners own about 10 per cent. But if you’re looking at the Chinese government and corporate bonds, all the bonds, then foreign ownership is only about 3 per cent.
“Therefore, you can see that the direction of bond markets is mainly driven by the domestic investors, while for other markets internationally you have a lot of flow coming in and out from different investors. So it is this feature that creates a different correlation impact of Chinese bonds versus other markets.”
The correlation with other emerging markets also depends on where we are in the cycle, he says. Most of the time the correlation is low, but under the influence of the pandemic it is now closer to moderate.
The direction of bond markets is mainly driven by the domestic investors, while for other markets internationally you have a lot of flow coming in and out from different investors. So it is this feature that creates a different correlation impact of Chinese bonds versus other markets
“More recently, we have seen COVID-19 impacting growth and so the correlation is pretty high because everyone is seeing a decline in bond yields,” he says.
“But if you are looking at the overall, longer term, then the growth patterns, cycles and monetary policies – some of the drivers of correlations – are quite different. If you would compare China to Latin America or the Middle East, then obviously they are very different.
“Even within Asia itself, China might be very integrated in terms of trade flows, but in terms of the bond market correlation it varies. Because of its low foreign ownership, China tends to be steadier.
“Markets like Indonesia or Malaysia, for instance, tend to have higher foreign ownership and so, therefore, the swing of emerging market sentiments would have a much bigger impact on the volatility of these markets. So comparatively, when you look at these markets versus that of China, you’ll find that the correlation can be quite low.”
For investors who want to reduce the volatility of their Chinese bond portfolio, he says the best way is to focus on organisations that have an explicit or implicit government guarantee.
“Central government bonds issued by the MoF (Ministry of Finance) plus also those issued by policy banks are the safest amongst all the Chinese bonds because they are likely to have the state’s support,” he says.
“Policy banks have implicit support because in China they don’t really make that explicit, but these are the ones that we feel investors would feel more comfortable with in the initial stage [of allocating to onshore bonds].”
Although there are clear benefits of allocating to Chinese bonds and access to them has improved in recent years, some investors might still experience some hiccups.
Japanese investors, including Japan’s Government Pension Investment Fund, are heavy users of the WGBI and, at the end of last year, expressed concerns about FTSE’s plans to include Chinese bonds.
Their concerns were mostly around technical issues, such as liquidity, settlement issues and foreign exchange risks, which were often related to the sheer size of the allocations that needed to be implemented.
Similar problems were seen in 2019 when Chinese bonds were included in the Bloomberg Barclays Global Aggregate Index.
Many investors experienced delays in setting up the requisite Chinese onshore accounts to enable the trading of these bonds and as a result Bloomberg offered a version of the Global Aggregate Index that excluded China alongside the main index, an option FTSE might contemplate as well.
Ng acknowledges the initial stage of implementation might cause some teething problems. “Some of the initial investments may be affected by clients’ readiness to get the account access fully up and ready, so this would be one of the challenges,” he says.
Another issue might be a review of the tax treatment foreign investors receive in China.
“Foreign investors, especially Japanese investors, have in the past also focused on tax issues and the Chinese government has recently said they would further exempt the capital gains tax from foreign investors. So this would hopefully address the concern,” Ng says.
But he is certain these issues will not stand in the way of foreign investors allocating more to Chinese bonds in the period to come, thereby raising the share of foreign ownership in this market.
“The percentage ownership will definitely increase. If I look at other emerging markets around the region, then you can see, for example, Malaysia and Indonesia, which have around 20 to 30 per cent foreign ownership. Thailand is a bit lower and is in the range of 15 to 20 per cent,” he says.
“Now, I’m not saying that it will get to that level soon, but it would not be a surprise to see a further increase in foreign ownership of Chinese bonds.”
The Inflation Bogeyman
With interest rates at record lows and talk about rising inflation starting to intensify, investors could ask the question whether this is the right time to introduce a new bond allocation. But Ng says the recent pick-up in inflation is unlikely to be a structural trend considering the broader macroeconomic picture in China.
“When we look at inflation we need to ask whether it is short-term, transitory inflation, or not. What causes the worst kind of inflation is a demand-pulled inflation. That means that the economy is really strong, there’s a lot of people beating up prices for different assets and so on. That is where the central bank would certainly tighten moderate policy,” he says.
“For China, the issue would potentially be commodities. If commodity prices are high, that could create some important inflation, but if it is mainly a short-term, supply-side type of issue, then it is not likely to create a lasting impact.”
Real estate prices have also gone up in China, but, again, he does not believe this is part of a structural story.
“Real estate prices are also going up because new projects cannot be built in time, so people that cannot wait will buy in the secondary market. That has pushed up the secondary prices a lot and this is a bit of a concern,” he says.
“Now, unless that becomes a permanent inflation driver, I don’t think it will cause central banks to be worried. In the case of China, clearly they are not concerned that there will be runaway headline inflation. Chinese authorities however are concerned that rising property prices may lead to speculative buying as investment, not for own stay. Hence, property tightening measures are expected to stay.
“I think what we are seeing across Asia, not just in China, is a temporary increase in inflation. I think that may be a function of the supply chain impact because some of the freight costs have been going up and, of course, more recently energy or oil prices also have gone up.”
Outside of China, the traces that COVID has left are more noticeable, especially when looking at labour costs. The many periods of lockdown the regions have gone through and that are still in place in certain countries have prevented people from travelling to the places where the jobs are, Ng says.
“Because of COVID, the movement of labour is less. In the so-called lower-cost labour countries, such as Indonesia, Malaysia and Vietnam, people do move around within the region and that is now being put to a stop,” he says.
“As a result, the construction sector is finding it hard to operate and even the services sector is finding it hard. But in China, labour costs have risen less because they have a huge labour pool.”
This article is paid for by State Street Global Advisors. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.