Bonds Apr 06

Bond investors swarm to China, the safe harbour

Monthly turnover hits a record high of $67.4 billion as activity picks up 

Bond investors swarm to China, the safe harbour

(ATF) – China’s domestic bond market has drawn huge foreign fund inflows, with yield differentials over other markets widening in a risk-averse environment, as the world’s second-largest economy becomes the first to recover from the deadly coronavirus pandemic.

These flows are expected to accelerate in the medium term as more international benchmarks include Chinese bonds in their indexes.

Bond Connect data shows March logged the highest monthly turnover of 478.2 billion yuan, indicating stepped up activity. 

“The inflow data in the Bond Connect report shows two trends, there is gradual increase in foreign investors’ Chinese bond holdings, indicating steady foreign investors’ appetite for Chinese bonds,” said Jing Sima, China Investment Strategist at BCA Research.

“The increase in foreign inflows into Chinese bond market since mid-2017 has been due to a structural allocation change (i.e. inclusion of Chinese bonds in major benchmark indices), rather than a change in foreign investors’ cyclical outlook on the Chinese economy or currency.

"The only positive news is that in the current environment, foreign investors in general do not seem overly concerned about the state of the Chinese economy,” said Sima.

Small but growing base

At 2.3%, foreigners’ holdings are still tiny when compared with developed markets such as Japan, where 12.1% of outstanding debt is owned by overseas holders, and the US (28%), as well as such emerging markets as Indonesia (39%) and Malaysia (24%). As yields came crashing down amid the onset of a recession, the gap widened against government bonds in China, stoking intense interest from yield-hungry foreign investors.

The US 10-year Treasury yield has plunged about 130 basis points (bps) since the start of the year, widening the gap over the China 10-year government bond yield to 205 bps from 130 bps.

“A healthy yield difference between China and other markets, especially DM, is attracting inflows to Chinese bonds. While most of the inflows have been from the official institutions, private-sector flows will also pick up as more Chinese bonds are added to the international indices,” said Chi Lo, senior greater China economist at BNP Paribas Asset Management.

This is drawing foreign investors who increased their holdings by 59.07 billion yuan in the first quarter alone. They now own 2.26 trillion yuan of Chinese domestic bonds. The number of foreign institutions has gone up by 26 to 822.

“Bond Connect trading continues to gather momentum as Chinese securities are becoming an asset class of rising importance and the ease of trading allowed for investors to capture investment windows in the most timely manner,” Julien Martin, the general manager at Bond Connect, said. 

“With ongoing operational enhancements driven by the People’s Bank of China (PBoC) such as settlement amendments and extended settlement cycles to cater for international investors’ needs, we expect trading and 'onboarding' activities to remain solid and robust,” he said.

Foreign presence

China has been slowly opening its doors to foreigners whose ownership in bond markets has leapt in the past two years as the different exposure avenues have emerged – the Qualified Foreign Institutional Investor (QFII) and RMB QFII (RQFII) schemes, direct investment in China’s interbank bond market (CIBM Direct) and Bond Connect.

“Bond Connect has been a game-changer. This new channel of access has allowed many investors to access China’s bond market without having to set up accounts domestically,” said Jinny Yan, the London-based chief China economist at ICBC Standard Bank.

“In the current environment CGB yields has become more attractive, particularly relative to developed market sovereign bonds. As long as currency risk can be hedged, CGB yields remain attractive relative,” said Yan. 

Index inclusion is key to drawing tracker fund flows as funds try to replicate indexes to track the performance of the benchmarks.

Despite their inclusion into the Bloomberg Barclays Global Aggregate Bond index, other global index providers have delayed the inclusion of Chinese bonds to their benchmarks due to market volatility.

FTSE Russell’s flagship World Government Bond Index (WGBI) is yet to include China in its benchmarks and last week JPMorgan said China’s weight in GBI-EM Global/Diversified and GBI-EM/Diversified will remain at 1%.

Shelter from the storm

But investors disagree, instead gravitating to China due to its relative calm. 

“World sentiment towards China is improving due to its early containment of the coronavirus outbreak, and this is making Chinese bonds look like a shelter in the global storm,” said BNP’s Chi Lo. "This is attracting inflows. The addition of Chinese bonds to the international bond benchmarks has drawn passive investors, and will continue to pull in more such inflows.”

The flows will possibly widen beyond government bonds, as investors prepare for further opening up of the world’s second-biggest bond market.

Last year, China’s onshore bond market overtook Japan's in terms of bonds outstanding and now ranks behind only the United States.

“Global investors have been prepping their internal operations to trade China Government Bonds (CGBs), then Policy Bank Bonds, and perhaps other high higher yielding bonds,” said Yan at ICBC Standard Bank.

“Fundamentals point to continued outperformance of CIBM compared with other markets, as China’s recovery is likely to front-run others with domestic supportive measures likely to lift the growth outlook starting in Q2.”

Indeed, the latest PMI data surprised on the upside, with China’s early shutdown of its economy after the coronavirus outbreak providing for an early recovery. 

The outlook continues to be bright for China’s government bond markets with the central bank cutting its reserve requirement and further expectations that it will make more interest rate cuts to support the economy.

Investors are already turning positive on the economy, with Morgan Stanley last week raising its overweight position on China’s equity markets.