Bonds Oct 14

China bonds the new global draw

A strengthening economy, rising yuan, US political unease and steep yield spreads continue to lure overseas investors to Chinese debt

China bonds now a global draw
“The inclusion of the FTSE Russell World Government Bond Index (WGBI) has driven overseas capital to withdraw funds from other emerging markets while still favouring yuan bonds.”

(ATF) While uncertainty over the US election and rising geopolitical tensions have triggered a withdrawal of global capital from emerging markets, foreign cash continues to flood into yuan-denominated bonds. 

By the end of September, the China Central Government Securities Depository and Clearing (CCDC) had managed 2.6 trillion yuan ($385 billion) of bonds for overseas institutions, an increase of 134.1 billion yuan from the previous month, Xinhua reported. 

This means that overseas institutions have increased their holdings of Chinese bonds by more than 100bn yuan for three consecutive months. Combined with data from the Shanghai Clearing House, the figures show foreign institutions held 2.9tn yuan of Chinese bonds at the end of September. Experts said that the inclusion of Chinese assets in a leading index had boosted inflow to yuan-denominated assets as China's economy recovered and its bond yields remained relatively more attractive than their foreign counterparts. 

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“The inclusion of the FTSE Russell World Government Bond Index (WGBI) has driven overseas capital to withdraw funds from other emerging markets while still favouring yuan bonds,” Aaron Kohli, a strategist at hedge fund BMO Capital Markets said, adding that reforms of the bond market last month also boosted sentiment.

More than 100bn yuan of foreign capital flooding into China in September, Kohli was reported as telling 21st Century Business Herald. 

An International Finance Association (IIF) report stated that capital was being withdrawn from riskier emerging market assets amid uncertainty surrounding the US election. As a result, the Bloomberg Barclays developing country sovereign dollar bond index fell 1.9%, the first monthly decline since March.

According to IIF data, fund inflows to emerging markets outside of Europe and Latin America reached $1.1bn and $1.6bn, respectively, even as about $4bn was pulled from the Chinese stock market.

Coronavirus concern

A chief representative of the Asia-Pacific region of a large European asset management agency told 21st Business Herald that yuan bonds continued to be favoured by foreign investors because the return of the epidemic in Europe and the US has prompted their central banks to continue easing monetary policy. That’s increased the relative attractiveness of yuan bonds, which have a high credit rating and relatively high yields.

"In fact, more and more large overseas asset management institutions have already strategically allocated yuan bonds as an independent safe-haven asset, which means that yuan bonds will continue to usher in a wave of overseas capital accumulation for a long time,” the representative said.

In the opinion of many Wall Street hedge fund managers, the main driving force behind the surge of foreign capital into yuan bonds last month September was no longer the currency’s appreciation, but the implementation of a series of new financial market opening policies. 

New regulations brought in last month by the PBoC – catchily entitled “Regulations on the Fund Management of Foreign Institutional Investors' Investment in China's Bond Market (Draft for Solicitation of Comments)” – define the relevant basis, concepts and scope of fund management for foreign institutional investors’ investment in China’s bond market. This has given added optimism to investors.

"The new regulations abolished restrictions on the remittance ratio of investments in single currencies, and the restrictions on foreign institutional investors handling spot foreign exchange settlements and sales through settlement agents eliminated the ease of entry and exit of funds by many overseas investment institutions,” an analyst was quoted as saying. “One after another, institutions began to strategically allocate yuan bonds." 

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The manager of a large Wall Street macroeconomic hedge fund said he plans to increase his asset allocation into yuan bonds to 9% from 4% after the introduction of the new regulations, the third-largest bond allocation in his portfolio after US and European bonds. The reason is that China's economic recovery prospects are better than those of European and American countries, and its bond yields are higher. Increasing the maturity limit of yuan bonds can increase returns on bond investment portfolios.

A Chinese banking specialist cautioned that the yuan exchange rate’s surge in August slowed the following month, and had caused many overseas institutions to slow the pace of yuan bond inflows. But that was outweighed by money drawn in by the inclusion of Chinese government bonds in the FTSE Russell World Government Bond Index (WGBI) at the end of September. That decision drove many passively-managed global bond ETFs to automatically increase their positions in yuan bonds.

"In the past few days, many active investment institutions have begun to increase their positions in yuan bonds,” a Hong Kong bank bond trader revealed. 

The main reason is that the yuan exchange rate has maintained a rapid upward trend during the holidays, encouraging investors to continue increasing their allocation of yuan assets. Also, the latest data from the US Commodity Futures Commission (CFTC) shows that short position on long-term US Treasury bonds have reached a historic high.

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The Chinese central bank lowered the foreign exchange risk reserve ratio for forward foreign exchange sales from 20% to 0% over the weekend, leading to increased fluctuations in the yuan exchange rate. Nevertheless, this did not halt the inflow of foreign money into yuan bonds.

"Although the slowing of the yuan's rise will weaken the exchange gains of yuan assets, the Sino-US interest rate differential remains high enough to allow them to reap the expected return on investment,” the banking specialist said. 

Since the beginning of October, the 10-year US Treasury bond yield has rebounded to 0.78% (about 10 basis points from the end of September), while the same-maturity yuan yield has hovered around 3.2%, keeping the spread at 241 basis points. After deducting transaction costs, overseas active investment institutions that increase positions in yuan bonds can still enjoy a 180 basis-point premium of annualised risk-free spreads. 

With such spreads on offer, some institutions with aggressive operating styles are doubling end even tripling their capital leverage to increase yuan bonds. The actual annualised risk-free spread return can reach more than 400 basis points.

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