Index inclusion to boost liquidity in China’s bond market

The inclusion of Chinese bonds in international indices will foster a more mature bond market with liquid benchmark rates.
China's onshore renminbi bond market is increasingly open to foreign investors.
China's onshore renminbi bond market is increasingly open to foreign investors.

The inclusion of Chinese bonds in international indices will expand the influx of foreign funds, which is likely to boost liquidity in China’s government bond market. This will ultimately increase the depth and sophistication of the world’s third largest bond market and create more liquid benchmark rates, similar to benchmark Treasury yields in the US.

More indices are expected to include Chinese bonds after the Bloomberg Barclays Global Aggregate Index started to add Chinese government and policy bank bonds from the beginning of April. In the middle of the month, another global index provider, FTSE Russell, announced that it might upgrade the market accessibility level of China’s onshore bond market from 1 to 2, the minimum level required for inclusion in its World Government Bond Index (WGBI).

Within three years, it is “very plausible” that foreign investors’ share of Chinese government bonds will rise to 20% from a current level of 8%. This is thanks to index inclusion and the relative attractiveness of Chinese government bonds compared to other markets, explains Brad Gibson, co-head of Asia Pacific fixed income at AllianceBernstein.

In comparison, foreign ownership of Malaysian government bonds is roughly 40% and foreign holdings of Indonesian high-yield sovereign bonds exceeds 35%, according to the official data of these countries.

“To have any chance of developing a vibrant corporate bond market, you need a liquid risk-free curve to benchmark corporate bonds off, like US Treasuries. You need a deep liquid risk-free curve to value all other financial instruments,” said Gibson.

At the moment, the vast majority of foreign investments in Chinese bonds lie in central government bonds, policy bonds and local government bonds, because Chinese corporate bonds are deemed too risky. For example, in Bond Connect, a Hong Kong platform for international investment in Chinese bonds, trading is more than 90% concentrated in policy bonds, negotiated certificates of deposit, and Chinese Treasury bonds. Sovereign bonds and policy bank bonds account for 35% of China’s outstanding onshore bonds, according to Moody’s.

In alignment with index inclusion, international investors have started to tilt towards Chinese government bonds and policy financial bonds. They accounted for 66% of turnover in Bond Connect in March, up from 37% back in December.

Foreign investors are prepared to invest in bonds at a yield level that is partly determined by the liquidity these bonds have.

One factor that will boost liquidity in China’s bond market is the anticipated inflow of foreign funds. A Nomura report at the end of March reckoned that the inclusion of Chinese bonds in the Bloomberg Barclays index alone would lead to total passive fund inflows of $110 billion by end-2020.

Index inclusion is sparking a wave of investment in Chinese bonds by global asset management firms like AllianceBernstein.

“We will be adding to our allocation to this market,” Gibson disclosed without giving details.

Although China’s $13 trillion bond market is huge, it is less liquid than the other two major bond markets like the US and Japan. The first wave of foreign investment just flowed into Chinese government bonds with little turnover.

“The first wave were buy-and-hold investors. This second wave will have asset managers who will probably buy and sell bonds,” Gibson said.

In this second wave, international asset managers will buy and sell Chinese government bonds more frequently unlike the more stable allocations from global reserve managers. This should hopefully lead to more secondary market turnover and liquidity in China bonds, he added.


In the short term, Chinese government bonds offer enticing pickings for foreign investors.

The Chinese market’s low correlation to major international bond and equity indices enhances its appeal to international investors, said Ong Guat Cheng, head of fixed income at Fullerton Fund Management.

The low correlation is due to the tiny fraction of foreign investment in China’s bond market. It stands at roughly 2%, which is far less than countries like Malaysia and Indonesia where foreign ownership exceeds 30%. “This increases its appeal to international investors looking to diversify from their core asset classes, as onshore Chinese bonds are less susceptible to external portfolio headwinds,” said Ong.

At the moment, $10.4 trillion of global bonds have a negative yield, while the average yield of Chinese government bonds is 3.25%. Japanese 10-year government bonds and German 10-year Bunds have a yield of nearly zero while equivalent Chinese government bond yields are about 3.4%.  

With index inclusion as well as Chinese government and policy bank bond curves being steeper than at the end of 2017, any rally is likely to be led by the 7-year and 10-year part of the curves in China, said the Nomura report.

The non-fungibility of securities in earlier schemes for foreign investors, such as Qualified Foreign Institutional Investor (QFII), as well as in newer schemes like Bond Connect remains a challenge. The option to shift assets from earlier schemes to more recent ones would be most welcome.

The inclusion of the bonds of non-policy banks and non-financial corporate bonds in all the major global bond indices is likely to take several more years, said a Moody’s report at the end of March. Challenges include weak disclosure standards in China’s onshore bond market, which hinders fair market pricing and efficient secondary trading. 

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