China debt: hedging, harmonisation key for investors

Even after Bond Connect, simplified rules and better hedging tools are needed for more meaningful foreign participation in the $9 trillion market, a conference hears.

Chinese internet companies may be pioneers in developing consumer-friendly applications, from digital payments to online shopping, but when it comes to the country’s $9 trillion domestic bond market, the innovations have stalled and international investors have yet to be won over.

At an industry conference in Hong Kong this week, foreign investors and bankers called for easier ways of doing business, even after Beijing launched Bond Connect in July to allow them to trade bonds in the interbank bond market without setting up an onshore account for the first time.

They also said they wanted more hedging tools to protect their downside risks after tighter regulations prompted a sharp sell-off in the world’s third-largest debt market last week, sending yields on sovereign and local government bonds climbed to their highest level in three years. 

One thing that would help is to better harmonise all the various regimes -- with their different abbreviations -- that foreign investors currently use to access China's onshore interbank bond market. 

“If you hold your securities in RQFII, you can’t sell it through Bond Connect or CIBM direct,” Stephen Chang, a Hong Kong-based fund manager at JP Morgan Asset Management, said at the annual gathering of Asia Securities Industry and Financial Markets Association in Hong Kong. “That remains a challenge to foreign investors."

Foreign investors, who were first allowed to tap China’s interbank bond market in 2012 through the quota-based Qualified Foreign Institutional Investors (QFII) scheme and the renminbi version of that, the RQFII, currently hold about 2% of all Chinese bonds, according to official data. Even with the introductions of CIBM direct (for institutions deemed eligible by the People’s Bank of China) and Bond Connect in the past 24 months, the two QFII channels remain the most popular way for foreigners to buy and sell Chinese bonds, according to fund managers.

That's not the only operational hurdle when trading Chinese bonds, said Chang, who heads the Asian fixed income team within his firm’s global fixed income, currency & commodities unit.

“If you have a Euroclear account you can trade bonds in different currencies. But in China, you have to set up each settlement account for each programme and that’s an operational inefficiency to me and adds potential error,” he said.

Indices and derivatives

The regular market swings have made foreign fixed income investors think twice before putting money to work in the world’s second-largest economy.

What also holds them back is the absence of Chinese bonds in the benchmarks that global investors closely follow. In a report this year, Goldman Sachs estimated that about $250 billion of new foreign capital could flow over 10 years into the Chinese bond market if global index providers such as JP Morgan and Barclays included the country in their indexes. 

For that, though, the market would first have to remove some of the barriers to investing -- including capital controls.

“If China wants to be part of the global indexes, it has to remove some obvious barriers such as the foreign exchange restrictions,” Danny Missotten, deputy head of global capital markets and funds services at Euroclear said on the same panel. “The more hurdles you have, the less likely you will be included in the index.”

China’s debt market has expanded ninefold in the past decade but a lack of market-friendly instruments and restrictions on capital movements has strangled its development. Most foreign investors in China are largely “long-only”, meaning they usually adopt a buy and hold strategy until the bond matures.

Apart from the cash market, investors find it difficult to mitigate their exposure to interest-rate and corporate risks.

Using derivatives like interest rate swaps or credit default swaps are some of the common tools used by professional investors overseas to protect themselves from big market swings or in the event of a corporate default.

"The next phases of development will be on interest rates and corporate derivates,” JP Morgan's Chang said. “But in China the use of interest rate derivates – through non-deliverable contracts – could be tricky, in part due to heavy documentations.”

Wilfred Yiu, deputy chief executive and chief operating officer of Beijing Gao Hua Securities, a domestic unit of Goldman Sachs, agreed that the legal and documentation framework was a big challenge for foreign investors in that respect.

“In terms of the risk deployment among foreign investors, it still needs to be addressed with policymakers in China to make a derivative market that is accessible and user-friendly,” said Yiu, who described it as one of the most frequently discussed topics among his clients.

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