Foreign investment in China’s onshore bond market is “no less significant” than the acceleration of “digitisation and sustainability” as consequences of the pandemic, according to Paras Anand, chief investment officer, Asia Pacific at Fidelity International.
“Investors are seeking diversification when the traditional hedges, such as balancing a portfolio of equities with an uncorrelated allocation to bonds (typically on a 60:40 basis), no longer work,” he told a media webinar on Thursday.
Several factors are responsible for the trend, including a sharp dislocation between the expansionary monetary and demand-targeted fiscal policies of the US (and Europe) and the more subdued central bank stimulus and supply-focused spending measures in China.
A depreciating dollar largely caused by those US policies, as well as better management of the pandemic in China (and elsewhere in Asia) which has prompted faster economic recovery, and — perhaps crucially — the inclusion of China government bonds (CGBs) in major indices are also compelling forces, argued Anand.
Other money managers agree, such as Indosuez WM’s Asia head of capital markets, Davis Hall, who believes that CGB’s will even be the new safe-haven for global investors during the next decade.
China’s onshore bond market is around $15trn, but the scale of foreign ownership is low compared with other leading domestic bond markets. Only about 2-3% of China sovereign and corporate onshore bonds are held by overseas investors, whereas about 25% of some major European (such as Spain) domestic fixed income securities are owned by foreigners, and as much 30% in the UK market, according to Fidelity data.
“So there is plenty of scope for foreign ownership to rise to its ‘natural’ level, especially if low correlations with other asset classes persist,” said Anand.
Venessa Chan, investment director at Fidelity, pointed out in the webinar that CGBs offer a substantial yield premium over other government fixed income securities, which should encourage overseas demand.
Yield premium
The yield on the 10-year CGB is currently 3.18%, according to Marketwatch data, which is substantially higher than the rate paid by US Treasuries (0.81%), Japanese Government Bonds (zero) and Germans bunds (-0.60%).
She also emphasised the importance of inclusion by the Bloomberg Barclays Global Aggregate Index last year and the planned entry of between $140bn and $170bn of CGBs into the FTSE Russell benchmark index in October 2021, which should induce benchmarked investors to make allocations to CGBs to avoid tracking error.
“The ability to earn incremental returns, to gain exposure to a low correlated asset class and the need to minimise index tracking error should combine to encourage substantial foreign investor flows into onshore Chinese bonds,” said Chan.
She also expects the People’s Bank of China to provide hedging instruments, such as CGB futures contracts, to enhance the market’s appeal to sophisticated overseas funds.
Although Fidelity believes foreign investors will focus mainly on government and policy banks bonds in the short-term as they become comfortable with China sovereign risk and familiar with investing channels such as the Bond Connect, the firm also sees potential for the growing local government bond market, and for the corporate fixed income sector, comprising about 5,000 different issuers.
“Foreign ownership of Chinese onshore bonds, in general, is likely to reach 8% from 3% within five years,” said Anand.
The greatest impediment to more rapid participation is poor liquidity, because many bonds are tightly held by local institutional investors; but “increased demand and the inflow of more capital should drive greater liquidity, creating a virtuous circle,” he said.
