China's big bang - bringing onshore bonds into focus

Chinese onshore bonds will be included in Bloomberg's global index from April 2019 and that's a big bang moment for China fixed income.

by Hayden Briscoe, Head of Fixed Income, Asia Pacific

Bloomberg's inclusion of Chinese onshore bonds into its main global index from April 2019, subject to certain conditions, isn't about market access - the market has been open for years.

We regard it as a "big bang" moment because it will force further reforms, compel international investors to take notice, and expand China's onshore markets into the second largest in the world in coming years.

In a world with little yield but attractive nominal and real yields onshore in China, this should prove to be an excellent investment opportunity for investors, who ought to prepare accordingly.

It's not about access

Fund managers may say that China's bond market is new territory, but we have been investing there for several years.

Starting in 2013, we invested through quotas on the China Interbank Bond Market, then without restrictions when limits were removed in 2017.

Today, the interbank market is open to all investors with a local custodian account and approval is straightforward.

Bond Connect offers an alternative to investors not resourced in the region with an onshore setup and also provides direct access to the markets.

It's about inclusion

From April 2019, Bloomberg has proposed to begin a 20-month process of adding over 300 bonds from policy banks and the government into its Bloomberg Barclays Global Aggregate Bond index benchmark.

The index providers have stipulated some aspects of settlement and tax clarification are requirements before the full implementation.

When completed, international investors that track the benchmark will have to allocate to China's onshore markets, and that amounts to a large commitment because the bonds included will account for an estimated 5.49% of the total index, or an projected market value of $2.94 trillion, according to Bloomberg data as of January 31, 2018.(1)

Three reasons why this is a 'Big Bang' for China's bond markets

The announcement came slightly earlier than we expected, but we think this is testament to both China's market access reforms in the past five years and overseas investors' demand for Chinese fixed income.

We see the index inclusion announcement as a big bang moment for Chinese fixed income for three main reasons.

Firstly, we believe other major indices will follow suit. Bloomberg's announcement demonstrates that international indices recognize China's steps to open its bond market and we expect other benchmark providers, like the Citibank World Government Bond Index, to surely follow.

Secondly, the RMB internationalization process will accelerate. We've had SDR inclusion, MSCI A share inclusion, central banks and sovereign wealth funds publicly announcing allocations to the RMB and Chinese bonds, countries becoming official clearing hubs for RMB, and new RMB-priced oil futures contracts starting

The reforms have been vast and the pace of reform continues to surprise on the upside. The bond inclusion from this perspective looks like a natural progression in a long list of opening-up measures already in place in China's financial markets.

Finally, the move will trigger a large-scale reallocation of capital to China's onshore markets.

Put simply, index tracking investors will have to shift their allocations to meet the benchmark weights when Chinese bonds are included, both in Bloomberg's index and other benchmarks.

Accelerating the transformation in China's onshore markets

Onshore markets have already been growing rapidly, reaching RMB 63 trillion (USD 9.7 trillion) at the end of December 2017, as China has moved from a bank-led financing system to one where capital markets play an increasing role.

Exhibit 1: China Onshore Bonds Outstanding (RMB trillions), Jan 2008-Jan 2018

Source: Wind, February 2018

Overseas investors will likely be more prominent because index inclusion will accelerate the reorientation of institutional capital into China's onshore bond markets seen over the past three years.

Overseas institutional investors' onshore bond holdings hit RMB 1.2 trillion in December 2017, three times higher than January 2014 and up 40% y-o-y.

Exhibit 2: Institutional Investors' Holding of Onshore Chinese Bonds (RMB Trillions), Jan 2014-Dec 2017

Source: Bloomberg, February 2018

China's onshore bond market is estimated to overtake Japan as the world's second largest bond market globally because there was a new budgetary law passed in 2015 requiring provinces or local governments to cease borrowing from banks and fund via publicly traded bond markets.

Exhibit 3: Bond Markets Compared (USD Trillion)

Source: Standard Chartered Bank, May 2017

Creating opportunities for investors

Index inclusion will put the investment opportunities in onshore Chinese bonds into clearer focus.

In our view, yields on government and policy bank debt offer compelling value compared to global developed markets.

The onshore market is liquid, primarily government backed bonds – seeing over RMB 100 trillion of turnover in 2017 – and government-backed bonds represent a safe investment since China is the second largest creditor nation in the world. There aren't many net creditor nations in the world of flat currencies left!

Exhibit 4: Bond Yields Compared: China, US, Japan & Germany, Mar 2017-Feb 2018

Source: Bloomberg, February 2018

We regard index inclusion as also supportive for RMB inflows, and that's why we are bullish on the RMB longer term.

At a time when the world is concerned about RMB outflows, that's an unfashionable position to take, but we believe that moves such as index inclusion and the creation of Petroyuan will force investors to think differently about Chinese assets.

Chinese bonds: An opportunity that's too big to ignore

In sum, Bloomberg's announcement marks a big bang moment for China's onshore bond markets because other indices will almost certainly follow, reforms will likely accelerate, and projected global capital flows will see the RMB continuing to internationalize as a currency.

Index inclusion will only add to the reasons why investors need to take notice of opportunities in China, and that's not a bad problem to have in a world of low yields. As we've highlighted, yields on China government bonds offer strong value, both in nominal and real terms, compared to developed markets.

Even investors not focused on China will have to take notice too, because developments in the China bond market will influence events in global bond markets.

Looking to the longer-term, we expect the range of onshore bonds included in global indices to not only cover government bonds, but also corporates, thus opening a brand new opportunity set for bond investors.

With these trends in mind, we see the changes in China's bond markets as an opportunity that is too big to ignore, and investors should prepare accordingly.

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