Chinese Bond Connect puzzle slowly unlocking

Foreign investment continues to accelerate as the government rolls out new measures, but many still fear making a leap into the unknown.

The opening up of China’s $12 trillion domestic bond market is arguably the most important event for the global bond market this century. At some point, fund managers know they will need to engage with, or at least understand, the world’s third largest bond market.

Many have already dipped their toes in the water. In July, foreign holdings of Chinese government bonds (CGBs) topped Rmb1 trillion ($146.26 billion) for the first time. During the first half of the year, foreign investors became the single biggest buyers for CGBs and now account for 8% of all holdings.

Demand has also increased month-on-month for the past 18 months, even as the renminbi began its slide against the US dollar. Brokers expect this pattern to continue.

Goldman Sachs, for one, predicts inflows of $1 trillion into China’s domestic bond market over the next five years. It expects $700 billion to $800 billion to pour into CGBs with the remaining $250 billion-odd into policy bank and corporate bonds.

The headline numbers look great, but do they tell the full picture about a market where overall foreign holdings still make up less than 2%?

In FinanceAsia’inaugural Bond Connect survey, we asked investors about key issues surrounding the market and Bond Connect, the market access scheme established by the China Foreign Exchange Trade System (CFETS) and Hong Kong Exchanges and Clearing (HKEX).

This trading link, which mirrors an existing Stock Connect scheme, enables offshore investors to buy and sell the full gamut of bonds traded on China’s interbank market through Hong Kong. It means that foreign investors do not need to set up an account on the Chinese mainland and can use their offshore banks to execute trades.

Since the scheme was launched in July 2017, the government has also rolled out a series of measures to improve its efficiency and usability.

In particular, the government needed to make three adjustments to fulfil the inclusion criteria for CGBs and policy bank securities in the Bloomberg Barclays Global Aggregate Index. China is scheduled to be included from next April and this should result in inflows of $137 billion once the country reaches its full index weight of 5.49% after a 20-month scaling-in period.

The first and most important adjustment was the introduction of a real-time delivery-versus-payment (DVP) settlement system for transactions through Bond Connect in late August. This represented a major step in reducing settlement risk for offshore investors. It had been a major barrier that prevented European Undertakings for Collective Investment in Transferable Securities (UCITS) from using Bond Connect.

The second adjustment concerned block trading, which was opened up to foreign investors on August 30. On the same day, the State Council also addressed the third issue and announced a three-year moratorium on both income tax and value-added tax for foreign investors on the interest income their bonds generate.

Other index providers are also expected to include China within the next couple of years, most notably the FTSE World Government Bond Index (FTSE WBGI), which has a tracking Assets Under Management (AUM) of $2.5 trillion and the JP Morgan Government Bond Index - Emerging Markets (GBI-EM), which has a tracking AUM of $220 billion.

HSBC estimates that China is likely to be given a 5% weight in the former, potentially leading to $125 billion of inflows and a 10% weight in the latter, equating to $22 billion inflows.

STILL UNDERINVESTED

Yet the picture which emerges from FinanceAsia’s survey, shows an investor base fearful of a market it feels it does not really understand. A total of 400 investors are approved to use the Bond Connect scheme.

Just over 90% of respondents in the survey are based in Asia, with the largest portion (33.3%) in Hong Kong. Nearly half are asset managers (48.1%), followed by insurance funds on 15%.

In broad terms, they are fully aware of China’s growing importance to global capital markets, but many are still held back by a perceived lack of information about it. That primarily covers undifferentiated credit ratings, the single biggest concern for investors whether they are using Bond Connect or not.

And then there is the issue of the Chinese language, cited time and again as a barrier by respondents. This is undoubtedly one of the reasons why roughly three-quarters of non-Bond Connect users feel they do not have enough information to make sensible judgments.

Unsurprisingly, 79.2% of respondents, who do not use Bond Connect, feel that the entry barriers to access are either: high (41.9%), very high (23.3%) or insurmountable (14%).

“Historical access limitations mean that foreign investors hold a relatively tiny portion of the market,” Bryan Collins, head of Asian fixed income at Fidelity International, told FinanceAsia. “China Interbank Bond Market (CIBM) Direct and Bond Connect are closed loop and not fungible, i.e. if you buy a bond through CIBM, it is only possible to sell the same security through CIBM and not Bond Connect.”

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) in 2016 and Bond Connect the following year, the two QFII channels remain the most popular way for foreigners to buy and sell Chinese bonds, according to fund managers.

For David Yim, head of Great China debt capital markets at Standard Chartered, the main issue that inhibits greater foreign participation in China is not the market plumbing but rather a lack of underlying investment opportunities.

“The hardware such as channels into China and trading facilities is ready for foreign investors, but what’s missing are a lack of investable bonds,” he said.

Yim said that foreign investors, at least currently, are only interested in safe-haven assets such as CGBs or debt issued by policy banks such as China Development Bank. He said they remain sceptical about onshore corporate bonds, which do not offer enough of a yield pickup over sovereign bonds to compensate for the added and potentially unquantifiable risk.

“In short, I think that the lack of liquidity in the onshore market and hedging tools, as well as distrust of the local rating agencies, are the major hurdles to get foreign investors into the domestic China market,” Yim concluded.

The survey data backs this up, with respondents suggesting that the participation of retail investors, similar to Stock Connect, could help to boost liquidity.

Tomorrow we will publish the second part of FinanceAsia's inaugural bond connect survey, revealing some of the obstacles bond investors face when investing in the onshore bond market. 

If you are interested to receive the full report or more information, please contact Keith Frith, Commercial Director, FinanceAsia.

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