China has made a concerted effort over the past few years to improve accessibility to its bond market for foreign investors and its growing inclusion in leading global bond indices has meant it is an exposure hard to resist.
The Chinese bond market is worth $13trn, the second largest in the world only behind the US, however, gaining exposure has until recent years been tricky due to governance and accessibility issues.
In April 2019, the Bloomberg Global Aggregate index began including Chinese RMB-denominated government and policy bank securities into its remit. Bloomberg forecasts the inclusion will attract an estimated $150bn of fund flows into the Chinese bond market.
Since Bloomberg's decision, numerous ETF issuers have launched products offering exposure to the Chinese government bond market, including Goldman Sachs Asset Management (GSAM), UBS Asset Management and KraneShares.
Following GSAM's launch of CBND late last year, the industry responded positively to the strategy but was hesitant given trade tensions between the US and China at the time and the difficulty in analysing the Chinese market.
One of the key attractions to the market is its reasonably low correlation with the rest of the world’s government bond markets. It has a correlation of 0.05 with UK and US government bonds as well as 0.07 correlation with German bunds, according to Schroders.
Another factor for the growing interest in Chinese bonds is the improved accessibility to onshore bonds which account for 90% of the market, according to JP Morgan Asset Management (JPMAM).
In 2017, the Bond Connect scheme was introduced which connects China’s interbank bond market with the rest of the world, enabling international investors to access and trade bonds directly on the China Foreign Exchange Trading System (CFETS).
In addition to Bloomberg including Chinese government bonds into its flagship index, JP Morgan also included the asset class into its range of emerging market indices in September 2019.
FTSE Russell, however, decided not to follow the trend and did not include Chinese bonds into its flagship World Government Bond index in around the same time. Goldman Sachs has said this could cost the firm up to $7.5bn.
Despite the size of China's bond market in comparison to its international counterparts, this is not being represented in its weighting in the indices by Bloomberg and JP Morgan, according to Oliver Smith, investment director at Sandaire.
Smith told ETF Stream: "Being included in the global index certainly helps with the investment case, as certain conditions have to be met for inclusion, but China is still a modest part of it with an overall allocation of just 5% even though it is the world’s second largest market."
Given China's weighting is modest at best, there is an expectation that this figure will grow given the market's momentum.
"Naturally, index weights change constantly and this will likely increase further given the size of the Chinese economy and its debt market."
Nonetheless, these inclusions have already sparked a growing need for investors to include the asset class into their allocation, according to Athanasios Psarofagis, ETF analyst at Bloomberg Intelligence.
“Chinese government bond yields are high in comparison with the rest of the world and adjusting for currency, it makes these bonds attractive for offshore investors right now,” Psarofagis added.
From an investor's perspective, this is the case as Smith said: "There is a reasonably supportive case for having a periphery allocation within portfolios both because of improved diversification and because yields, even on a hedged basis, are more attractive than other areas.
"The 10-year yields are back almost to pre-COVID levels (2.8%) while interest rates have been cut by less than in other economies."
In addition to the asset class’s inclusion in leading indices and low correlation with the rest of the world, default rates are significantly low at less than one basis point, according to Dr Xiaolin Chen, managing director and head of international at Kraneshares.
“Since the launch of Bond Connect, the process for allowing investors to access the onshore bond market becomes simpler, easier and more flexible,” said Chen.
Another factor for the Chinese bond market that Chen said has improved in recent years is the onshore coverage by global rating agencies.
In a guide about the Chinese fixed income market, JPMAM highlighted this as one of the key considerations for investing in the Chinese fixed income universe. S&P’s Global Rating is the first agency to be given access to the Chinese market with Moody’s Investor Services and Fitch Ratings in the process of acquiring their licenses.
The report, written by Hannah Anderson and Vincent Juvyns, said the return potential of the Chinese onshore bond market is likely to increase as foreign portfolio flows, driven by benchmark inclusions, could support bond prices and further develop the market for longer maturities.
This is already being seen as China bond products have received $400m inflows year-to-date, according to Psarofagis.
If Chinese government bonds can maintain the higher yields they hold compared to other similarly rated peers, these assets are likely to continue growing but face a battle with the US.
Rabener commented on the limited data available on the market structure and the relationships between the government, municipalities, and corporates are not transparent, especially not to foreign investors. This has not changed significantly in recent years, although the size of the bond market has increased considerably.
"US investors are indirectly financing the Chinese government and firms by allocating to global and emerging market bond mutuals funds and ETFs," Rabener said. "US President Donald Trump has already started threatening Chinese firms listed in the US and there have been similar thoughts on considering restrictions on US capital allocations to Chinese bonds."
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