China onshore bonds will be added to the Bloomberg Barclays Global Aggregate, Global Treasury, and EM Local Currency Government indices in a staged, gradual process from April 1, 2019.
We sat down with our fixed income teams across the world to understand just how significant this event is and what opportunities there are for investors.
- Bloomberg's inclusion of China onshore bonds is a major change for global capital markets and will soon propel the onshore market past Japan as the second largest in the world;
- Inclusion is also a huge opportunity to diversify sources of alpha, since the market is attractive from a yield pick-up, duration, and correlation point of view compared to other more developed bond markets;
- Now offers an excellent entry point into China fixed income because the inflows implied by index inclusion, plus the prospect of China's economy recovering, puts tighter yields in prospect later in 2019;
- China's onshore markets are more accessible than ever and investment opportunities are compelling but on-the-ground resources and knowhow remain vital to unlocking value.
Putting our views together
Index inclusion is a process
In part, that's because of the nature of what Bloomberg is proposing. The inclusion starting in April means China bonds go straight into a global benchmark, not a regional one. That reflects just how significant the onshore China market has become in terms of size and how much it is expected to grow in the coming years.
Additionally, the inclusion is part of what we believe is a bigger process that we expect will mean that other index providers, like FTSE Russell and JP Morgan, will soon announce that they will bring China bonds into their indices too, which will spark additional capital flows into the onshore China market.
But it's not just about the weight of passive money that track benchmark indices, active investors will have to track the benchmark too, and central banks and sovereign wealth funds will also have to increase their China allocations as the world rebalances to China.
What this means for domestic markets is more liquidity and pressure on local operators to move quickly to adapt to the standards of corporate disclosure and trading that international investors expect. China still has to make progress here but we detect a constructive attitude from regulators we speak to and a strong incentive –purely through the size of the opportunities created by index inclusion – for local operators to adapt.
Onshore market offers attractive opportunities for investors
Following inclusion, China onshore bonds will be the fifth largest constituent by currency, with more than 300 issues within the index1, which offers plenty of opportunities and flexibility to express investment views from a bottom-up perspective.
From a top-down perspective, the inclusion of China onshore bonds is also an additional source of duration, offering more ways to take advantage of the relative value across markets. In particular, China's central bank may adopt a divergent policy approach from other global central banks, representing an additional layer of opportunity.
And valuations within China are currently attractive. Compared to the broad global bond market, the average duration on Chinese onshore bonds is lower, and the yield pick-up is often compelling.
As such, we see this as an attractive opportunity set because of the unique characteristics of the bonds being added to the index. This will help to further diversify risk and return sources, offering a potential yield pickup as well as a relatively low correlation to other fixed income markets.
Investors won't be able to ignore the Chinese market and global capital allocation will shift to China Looking at the bigger picture, we believe index inclusion across China's bond and equity markets is highly likely to force a process of rebalancing of global capital to China. China continues to drive the world economy - delivering 33% of additional GDP growth in 20192 – but China's markets account for less than 5% of invested capital globally.3
This rebalancing process is happening, with inflows into equity and fixed income markets seeing a marked increase during the past 18 months as the index inclusion processes have started to take effect. As China accounts for larger shares of global benchmarks, as we expect, flows into China will continue to grow.
Furthermore, China's growing clout in the world economy and the sheer range of investment opportunities in domestic markets mean that, eventually, a standalone allocation to China will make more sense than just including it through a comparatively restrictive emerging markets index allocation.
We speculate that as China's weight in the world's financial markets grows, its weight as a currency bloc will grow too. We live in a world dominated by the USD and Euro. But with China's steady move to internationalize its currency - through opening its financial markets, pricing oil and other imports in RMB, promoting Belt & Road, and taking a much more influential role as a trading nation in the APAC region – as well as China's huge weight in the global economy, we believe the world will evolve into a 3 bloc model: one that is euro-, Swiss franc- and sterling- denominated; one RMB-denominated in the Asia-Pacific region; and one USD-dominated.
But China still presents challenges
For all that we see positive aspects from the index inclusion process, China still presents challenges for investors - and being mindful of these is vital.
Access has improved dramatically, but the market has not been through continuous credit quality scrutiny in the same way that developed market bonds have been. There's also a big difference between how domestic and overseas credit ratings companies rate issuers, investors will have to be mindful of these differences and watchful of how overseas raters are allowed to develop their businesses and capacity in China.
Additionally, while the rates markets are relatively well- established, credit markets are still relatively underdeveloped, and it's hard for offshore investors to trade credits with local partners as ask-bid spreads can vary significantly. For credit, better market making mechanisms and more transparent corporate default processes are also necessary for offshore investors.
Looking longer-term we want to see further reforms in China, such as making central bank monetary policy independent from political influence, and to be mainly guided by maintaining inflation below 3% over the
medium term. Finally, we want to see the authorities let the market determine bond yields, lending rates and deposit rates, with the central bank only controlling the overnight or 7-day repo rate.
So investors need to be mindful of both the challenges and investment challenges and the differences between China and more developed markets. In this important respect, onshore resources and market knowhow are going to be absolutely vital to unlock opportunities and interpret the market.
Despite challenges, we believe the opportunities from China's continued development remain compelling, and index inclusion will add further weight to a process that, more than ever, will make China just too big to ignore for investors across the world.