The rise of China’s bond market

China bonds will become an important component of global bond portfolios. Following its upcoming inclusion into global bond indices, investors can no longer ignore the higher yields and lower correlations offered by the world’s third largest bond market.

Virginie Maisonneuve, Chief Investment Officer
Low Guan Yi, Chief Investment Officer, Fixed Income
Eastspring Investments

Mar 2019


China A shares’ inclusion into the MSCI Emerging Market Index was an important milestone for China’s financial markets. The upcoming inclusion of China Bonds into global bond indices will be equally ground breaking.

From April 2019, the Bloomberg Barclays Global Aggregate Index is expected to start including China Government Bonds (CGB) and policy bank notes into the benchmark, phased over a 20-month period. Upon full inclusion, China is estimated to constitute 6.03% of the index.

This suggests that we could see up to USD151 bn of inflows from investors who are benchmarked to the index. Potential inflows can reach as high as USD296 bn if other global bond indices follow suit. See Fig. 1. Over time, additional inflows cannot be ruled out as non-benchmarked investors increasingly view Chinese onshore bonds as an important component of global bond portfolios.

Fig. 1. Estimated bond inflows into CGBs and policy bank notes upon full index inclusion1

china-bonds-fig-1

The shifts in global allocations to the Chinese bond market are already happening ahead of the inclusion. Total inflows into the Chinese bond market in 2018 hit USD77 bn, almost a three-fold increase from 2016, helped by attractive yields, improved market access and increased allocation to the CNY by global central banks.

Can’t stop the inevitable

The Chinese bond market is currently the third largest in the world with a market capitalisation of USD12 tr. It will only get bigger. China’s bond market capitalisation as a percentage of GDP is around 100%, significantly below that of the US (225%), Japan (260%), UK (225%) and France (175%). Given China’s higher nominal GDP growth rate, Goldman Sachs estimates that China’s bond market can double in the next four years to USD24 tr.

With the growth of China’s bond market, together with the impending inclusion(s), foreign investors cannot ignore China’s bond market for much longer. Foreign ownership of Chinese government bonds currently stands at 7.9% (as at end 2018), substantially below levels seen in Indonesia (36.6%) and Malaysia (38.8%).

Demand for China’s bonds will also rise as global central banks increase their allocation to the CNY. The CNY’s share of global reserves rose from 1.1% in 4Q16 to 1.8% in 3Q18, reaching levels comparable to that of the AUD (2%) and CAD (2%) but still below the GBP (4.5%) and the JPY (5%). Anecdotal evidence suggests that foreign central banks invest their CNY-denominated reserves largely in CGBs and policy bank notes, and to a lesser extent Negotiable Certificates of Deposit (NCDs). With global central banks seeking to further diversify their currency reserves away from major currencies, increased stability of the CNY going forward will help to lift demand for Chinese government bonds and policy bank notes.

The appeal of Chinese bonds

10-year CGBs currently offer a yield pick-up of 47 basis points and 303 basis points above 10-year US Treasuries and German Bunds respectively2. This is following a 2018 rally which saw 10-year CGB yields fall from 3.9% to 3.3%. In the near term, with the Chinese government expected to ease monetary policy further to help stabilise the slowing Chinese economy, this should be supportive of Chinese bonds in general.

More importantly, as the Chinese bond market is still largely driven by domestic factors, its low correlation to both developed and emerging market bonds potentially provides active managers with alpha opportunities and diversification benefits. See Fig. 2 and 3.

Fig. 2. CGB: Correlation with Developed Market government bonds3

china-bonds-fig-2

Fig 3. CGB: Correlation with Emerging Market government bonds4

china-bonds-fig-3

Ironing out the kinks

Several issues, however, still need to be addressed for investors to fully participate in China’s onshore bond market. For one, there are concerns over the liquidity in the secondary market for CGBs, which tend to be held to maturity by Chinese banks. A reform of the credit rating system is also overdue - domestic credit agencies have often been criticised for issuing overly high ratings. For example, currently about 40% of Chinese corporates are rated triple-A by domestic rating agencies, far above the global average. Besides more objective credit ratings, investors would also need access to onshore currency hedging as well as bond derivatives including repos and futures for efficient portfolio management. Rising defaults and CNY volatility can also erode investor confidence in the market.

The Chinese government is firmly committed to further open up the Chinese bond market. In 2018, it implemented delivery versus payment settlement and enabled block trade allocation capabilities. It also exempted foreign investors from tax on interest for bond investments made from November 2018 to November 2021. These were all pre-conditions set by Bloomberg for inclusion in the index. More recently this year, the People’s Bank of China gave S&P Global permission to start assessing domestic bonds, the first foreign company to do so. This will lend greater clarity to foreign investors.

As the Chinese authorities continue to improve access to China’s bond market, the writing on the wall is clear. Chinese bonds will become an important component of global and Asian bond portfolios - investors will be well served to get prepared.


Virginie-Maisonneuve

Virginie Maisonneuve

Chief Investment Officer

Eastspring Investments

Low-Guan-Yi

Low Guan Yi

Chief Investment Officer, Fixed Income

Eastspring Investments

How to invest in Eastspring's fund(s)

Sources:
1 Citi Research estimates. February 2019.
2 Bloomberg. As of 7 February 2019.
3 Yield Book data from March 2009 to December 2018. Citi Research.
4 Yield Book data from March 2009 to December 2018. Citi Research.

This document is produced by Eastspring Investments (Singapore) Limited and issued in:

Singapore and Australia (for wholesale clients only) by Eastspring Investments (Singapore) Limited (UEN: 199407631H), which is incorporated in Singapore, is exempt from the requirement to hold an Australian financial services licence and is licensed and regulated by the Monetary Authority of Singapore under Singapore laws which differ from Australian laws.


Hong Kong by Eastspring Investments (Hong Kong) Limited and has not been reviewed by the Securities and Futures Commission of Hong Kong.


Indonesia by PT Eastspring Investments Indonesia, an investment manager that is licensed, registered and supervised by the Indonesia Financial Services Authority (OJK).


Malaysia by Eastspring Investments Berhad (531241-U).


United States of America (for institutional clients only) by Eastspring Investments (Singapore) Limited (UEN: 199407631H), which is incorporated in Singapore and is registered with the U.S Securities and Exchange Commission as a registered investment adviser.


European Economic Area (for professional clients only) and Switzerland (for qualified investors only) by Eastspring Investments (Luxembourg) S.A., 26, Boulevard Royal, 2449 Luxembourg, Grand-Duchy of Luxembourg, registered with the Registre de Commerce et des Sociétés (Luxembourg), Register No B 173737.


United Kingdom (for professional clients only) by Eastspring Investments (Luxembourg) S.A. - UK Branch, 125 Old Broad Street, London EC2N 1AR.


Chile (for institutional clients only) by Eastspring Investments (Singapore) Limited (UEN: 199407631H), which is incorporated in Singapore and is licensed and regulated by the Monetary Authority of Singapore under Singapore laws which differ from Chilean laws.


The afore-mentioned entities are hereinafter collectively referred to as Eastspring Investments.


The views and opinions contained herein are those of the author on this page, and may not necessarily represent views expressed or reflected in other Eastspring Investments’ communications. This document is solely for information purposes and does not have any regard to the specific investment objective, financial situation and/or particular needs of any specific persons who may receive this document. This document is not intended as an offer, a solicitation of offer or a recommendation, to deal in shares of securities or any financial instruments. It may not be published, circulated, reproduced or distributed without the prior written consent of Eastspring Investments. Reliance upon information in this posting is at the sole discretion of the reader. Please consult your own professional adviser before investing.

 

Investment involves risk. Past performance and the predictions, projections, or forecasts on the economy, securities markets or the economic trends of the markets are not necessarily indicative of the future or likely performance of Eastspring Investments or any of the funds managed by Eastspring Investments.


Information herein is believed to be reliable at time of publication. Data from third party sources may have been used in the preparation of this material and Eastspring Investments has not independently verified, validated or audited such data. Where lawfully permitted, Eastspring Investments does not warrant its completeness or accuracy and is not responsible for error of facts or opinion nor shall be liable for damages arising out of any person’s reliance upon this information. Any opinion or estimate contained in this document may subject to change without notice.


Eastspring Investments (excluding JV companies) companies are ultimately wholly-owned/indirect subsidiaries/associate of Prudential plc of the United Kingdom. Eastspring Investments companies (including JV’s) and Prudential plc are not affiliated in any manner with Prudential Financial, Inc., a company whose principal place of business is in the United States of America.