Bond Connect concerns could stymie 2018 index inclusion

Half a year after the launch of mutual market access scheme Bond Connect, experts are divided on whether major index providers will include Chinese bonds into their main bond indexes this year, forcing major investors to follow suite.

Increasingly, bond experts believe that China’s onshore bonds will receive a weighting. But some point to issues such as investor unfamiliarity with China’s bond market and lingering issues with Bond Connect following its launch as reasons why inclusion could be delayed a year or more.

Karan Talwar, the emerging market fixed income specialist at BNP Paribas, is among the optimists.

“Within the first half of 2018 we expect either JP Morgan or the Bloomberg Barclays Global Aggregate Index to … potentially include onshore Chinese government bonds and policy bank bonds in their global indices,” he told AsianInvestor.

“We feel that there is a strong case for inclusion this year,” agreed Manu George, senior investment director of Asian fixed income at Schroder Investment Management.

Talwar pointed to China’s inclusion in the Special Drawing Rights Basket by the International Monetary Fund in 2016 (a nod towards the renminbi’s increasing integration into the global financial system), the opening up of Bond Connect last July, and the inclusion of Chinese bonds in certain customised indices as positive steps towards a major bond index inclusion.

Several non-mainstream indexes already incorporate onshore Chinese bonds, including the JP Morgan GBI-EM Broad and the JP Morgan Asia Diversified index, the Bloomberg Barclays Global Aggregate + China index, and Markit iBoxx ALBI index.

However, the major global indexes followed by international bond funds— the JP Morgan GBI-EM, Bloomberg Barclays Global Aggregate Bond Index, and FTSE Russell WGBI Index—do not do so yet. Were they to do so it would lead bond funds to shift hundreds of billions of dollars into Chinese bonds just to maintain a neutral position against their index benchmarks.

Talwar expects at least one of the three to include onshore Chinese bonds this year. “Based on the projected weight of China in these indices and amount of assets managed against these indices, we expect $200 to 250 billion in inflows,” he said.

“An average figure would be around $150 billion to $250 billion, and a very aggressive number could be $300 billion,” concurred George.

Understanding issues

But not everybody is as sanguine about Chinese bonds being absorbed by the lead indexes this year, especially given how unfamiliar many investors remain with the country’s local bonds.

“Bond Connect’s only been going for six months,” pointed out Ashley Perrott, UBS Asset Management’s head of Asia fixed income. “I think the feedback from a lot of international investors who would particularly be using these indices might be, ‘we’re not quite ready.’”

“I think it’s more likely this time next year, rather than to happen at this round of review,” he told AsianInvestor.

Lingering operational issues with Bond Connect could also drag out the index inclusion process. These issues include China Central Depository & Clearing Co.'s (CCDC) lack of a true delivery versus payment system (DVP). The CCDC is one of two onshore custodians for Bond Connect along with the Shanghai Clearing House, and its current settlement process requires the buyer to make a cash payment first before bonds are delivered.

“That’s important for a lot of international investors from a credit risk and counter party risk perspective,” Perrott explained, “that you actually get delivery of the bond at the same time as you actually give them your cash for that bond.”

Lacking a completely reliable DVP could stop certain foreign investors from investing, BNP’s Talwar admitted. However, he argued that it isn’t a hard or essential requirement among the major bond index providers for index inclusion, and said he believes it will be resolved within the year.

The myriad of different channels into the onshore bond market can also complicate matters for foreign investors used to the straightforward accessibility of the European and US fixed income markets, George said. Currently they can access China’s bond market via Bond Connect, the RMB Qualified Foreign Investor scheme (RQFII), the Qualified Foreign Investor scheme (QFII), and the China Interbank Bond Market (CIBM) Direct.

“Those two challenges [a lack of investor readiness and complexities of onshore access] are still areas which leave index providers a bit challenged about wanting to wholeheartedly include Chinese bonds in their indexes,” he said.

But George was quick to add that the potential benefits of bond inclusion outweigh these concerns. For example, more foreign investments into China’s bond market would help improve liquidity, secondary trading, offer better price discovery, and improve the external visibility of China’s fixed income market.

Rising investments

Regardless of bond inclusion or Bond Connect issues, foreign ownership of Chinese fixed income is continuing to increase, Perott said, albeit from very low levels to begin with.

“The bond market there is huge, so moving the foreign ownership percentage is a slow process,” he said.

The value of China’s bond market was estimated at Rmb65.7 trillion ($9.5 trillion) as of March 8, 2017, according to Chinese financial data firm Wind. However, a May report by Hong Kong Exchanges and Clearing showed foreign participation to be just 2.52% of overall AUM in the Chinese bond market.

Talwar said a key aspect that could attract more foreign investor flows into China will be the higher yields available versus other markets—especially in Chinese government bonds.

“China’s onshore government five-year bond yield is at 3.9%” he told AsianInvestor. “The Bloomberg Barclays Global Aggregate Bond Index, which has much higher interest rate risk—yields here are around 1.7%.”

Data from state-owned settlement company showed the Chinese government’s five-year government bond yields stood at 3.85% on January 5. The Bloomberg Barclays Global Aggregate Bond Index’s yield was 1.69% on the same date, according to Bloomberg data.