(ATF) International holdings of Chinese bonds passed a significant milestone this month of 110 billion yuan ($15.5 billion) in May, despite global tension and volatility. Chinese bonds are increasingly becoming an attraction for foreign institutional investors.
But why is this phenomenon taking place? ATF has taken a closer look at some of the issues involved.
In May, the Chinese bond market experienced a wave of rapid adjustments and these have continued up to June. Currently, there are no signs of market stabilisation. On Friday June 5, treasury bond futures oscillated within a narrow range in the morning, before falling sharply in the afternoon. The main contract fell by 0.20%, the 5-year main contract fell by 0.30%, and the 2-year main contract fell by 0.17%.
However, in the eyes of international investors, the volatility of China's bond market does not stop them from buying.
According to May 2020 data of bond custody (by investors) released by the Central Clearing Company on June 2, the amount of bonds held by foreign institutional investors increased significantly. In May the figure was 211.307 billion yuan, an increase of nearly 112 billion yuan from April and a rise of 31.2% year-on-year.
This was the 18th consecutive month that international institutional investors have increased their holdings of Chinese bonds since December 2018.
As an important channel for foreign investors to participate in China's bond market, the average daily trading volume of Bond Connect reached a new high. The data it disclosed recently revealed that May saw a total of 5,824 transactions and volume of 468.2 billion yuan. The net inflow was stable, with an average daily transaction of 26 billion yuan, a record high. From the perspective of bond types, apart from policy financial bonds, government bonds and interbank certificates of deposit, local government bonds were relatively active this month, with a monthly turnover of 8.6 billion yuan, 6.6 times the same period last year.
World's top asset managers
As of the end of May, the number of foreign institutional investors entering the market reached 1,951, including 70 of the world's top 100 asset management companies.
According to CNPC Data, the total sales volume of US debt hit a record high in March, reaching $225.7 billion. Of this, China sold $10.7 billion – it has sold a large amount of US debt over the past two years. In the 19 months to March this year, China has sold $125.6 billion of US debt, so the scale of US debt held by China has fallen to $1.08 trillion.
The CNPC data shows that 28 countries are dumping US debt to buy Chinese bonds. According to a recent survey conducted by CICC (separate to CNPC), most of the investors surveyed believed that the number of international institutions planning to boost their holdings of Chinese bonds would increase significantly this year, and the volume may reach 700 billion yuan or even 1 trillion yuan ($142 billion).
Since the beginning of this year, international pension funds have actively entered the market, and 20 of the world’s top 100 pension institutions have completed a filing, and many are in the process of applying to do this. Bond Connect continues to introduce medium and long-term institutional investors to the interbank market.
It is worth noting that the US domestic bond market continued to adjust in May. As of today, starting from the sharp fall in the bond market at the end of April, the main 10-year Treasury futures contract fell from 103.470 yuan to about 100 yuan today, a cumulative decline of more than 3%. The current 10-year Treasury bond yield is approximately 2.83%, up 30-40bps from a low point in late April.
At the same time, the yuan exchange rate weakened in May, and both the onshore and offshore yuan exchange rates depreciated against the US dollar to some extent.
Boris Schlossberg, head of macroeconomic research at BK Asset Management, bluntly stated to 21st Century Business News that as the US dollar exchange rate is trending downward due to the Fed’s unlimited QE policy, and the market expects that the Fed will start Treasury yield curve control (YCC) monetary easing measures in June. In the future, demand for yuan bonds to warehouse overseas capital will continue to increase, and the net monthly warehousing amount will continue to hover around a scale of 100 billion yuan.
Yuan exchange rate weakening
Chang Zheng, head of the Oriental Jincheng International team, said although the yuan exchange rate may have weakened in May, market sentiment fluctuations and liquidity factors were the main reasons for this change. The fundamentals of the Chinese economy are actually stabilising and the market believes there is no basis for continued devaluation of the yuan.
Chang Zheng believed that continuous corrections of the bond market since May were mainly due to the tightening of funds due to the concentrated issuance of local special bonds, and the market’s differences in the pace of the central bank’s future monetary easing. So, the kinetic energy "must be corrected". In general, under the prospect that policy rate cuts will continue, the probability of the domestic bond market changing from bull to bear is unlikely. Therefore, for foreign-trading investors, the May bond market adjustment provides a favourable opportunity to enter the market.
The current institutions investing in China's bond market are mainly central bank bodies and commercial institutions such as foreign banks and asset management groups. Most of their holdings of yuan bonds are due to yuan asset allocation and risk hedging needs. Therefore, short-term fluctuations in the bond market are not currently a focus for them.
Aaron Kohli, a strategic analyst at BMO Capital Markets, a hedge fund, told 21st Century Business Herald the reason foreign investors increased their holding of yuan bonds in May was that, on the one hand, strains in Sino-US relations caused overseas capital to worry about the prospects for a global economic recovery. The configuration strategy of investors had been adjusted. The specific approach is to reduce equity investments and increase holdings of fixed income assets. That caused a surge in the amount of yuan bonds held by foreign investors.
Meanwhile, China's “Regulations on the Management of Domestic Securities and Futures Investment Funds of Foreign Institutional Investors” issued in early May created a positive effect, and this started a new wave of overseas institutions buying yuan bonds.
In addition, the current yield of China's national debt has a clear relative advantage over the world's major developed economies such as the United States, Japan, and Europe. It is also more stable than other emerging economies in the world. Therefore, China's bond market still has a low-lying value. The 10-year Treasury spread between China and the United States has hovered near a historical high of around 200 basis points since March.
Looking ahead, if there is no major recurrence of the global coronavirus epidemic in the short term, foreign institutions’ holdings of Chinese bonds should continue to rise.
Increasing internationalisation foreseen
In the medium to long term, as China's bond market continues to simplify management and facilitate operating procedures, the convenience of foreign capital entering the market will continue to increase, and foreign institutional investors' willingness to put cash into the Chinese bond market is expected to continue to rise. It is expected that while China's bond market ushers in more overseas funds, not only will the number of overseas institutional investors grow steadily, the sources of investment will be more widely spread around the world. And the types of investors will also be more diversified, thereby accelerating the opening of the bond market and continuing to raise the level of internationalisation.
Jing Shun, head of fixed income Asia Pacific at Jingshun, told state broadcaster CCTV that it is not only Asian investors who are involved, but investors in Europe, the Middle East, Africa and North America – constantly increasing their allocation in Chinese bonds, and this proportion is expected to rise further over the next three years. Analysts said that foreign investment continued to increase in Chinese bonds, because of their attractive yields and the continuous opening of the bond market.
The opening up of the bond market has cleared obstacles for foreign investors to enter, including a relaxation of access qualifications, an expansion of investment product ranges, an increase in the convenience of investment transactions, and the approval of related risk-hedging operations. In particular, from 2016 to 2017, foreign institutional investors directly entered the inter-bank bond market (CIBM) and "Northbound", which greatly broadened the channels for foreign capital to enter the Chinese bond market.
This spring, after the epidemic hit, China rushed through its new securities law, partly to improve transparency to acceptable levels, as well as outlaw certain activities with heavy penalties. Soon, after the NPC meeting, the amended securities law is likely to be incorporated in the criminal code – threatening longer sentences for people who commit fraud or violate bond and equity trading laws than in the US or Japan. The push for this change is led by the head of the Shenzhen Stock Exchange.
Aaron Kohli from BMO revealed that many foreign actively managed investment funds have adopted a trading spread arbitrage strategy in the domestic bond market (bond prices fall but yields rise) and selling off government bonds. Gold bonds can only be bought after the relevant bond prices have fallen, and at the same time they have obtained an expensive high-selling low-purchase income.
A US bond investment fund manager revealed that the above operations brought them about 30 basis points of additional income. If the leverage ratio of funds is taken into consideration, the actual return from selling high and buying low in May is about 120 basis points. "At present, we still have a certain gap in the allocation of yuan bonds, and we intend to make up for it when the price of government bonds continues to fall."
At the same time, many overseas investment institutions have taken a different approaches, paying close attention to the investment opportunities of urban investment bonds and private enterprise credit bonds.
As the Chinese investment bolt hole grows in these troubled times, and the Chinese bond market becomes more diverse and transparent, please turn to ATF for daily updates.