China bond index impact seen dwarfing MSCI effect

MSCI’s inclusion of Chinese A-shares earlier this year has already seen billions of dollars-worth of capital flowing into the A-share market and it could become hundreds of billions over the next decade.

Impressive though that is, though, this shift in equities investment could take second billing to fixed income flows once Chinese bonds are included in major global bond indices, according to some index fund specialists.

As much as equities get a lot of attention, it is China's fixed income inclusion that could have the bigger impact, Brendan Ahern, chief investment officer of China-focused exchange traded funds (ETFs) provider KraneShares, said at an ETF event in Hong Kong last week.

The inclusion of 234 Chinese A-shares in the MSCI Emerging Markets Index on June 1 has already resulted in the portfolio value of northbound A-share holdings increasing by $46 billion between June 2017 and September 2018, according to MSCI research.

That's just for starters: CSOP Asset Management estimates that about $400 billion will flow into the A-share market over the next decade because of the inclusion.

However, the potential flow of capital could be even more staggering come the April 2019 inclusion in the Bloomberg Barclays Global Aggregate Index of Chinese government and policy bank bonds, thinks Ahern.

“The Global Aggregate has $55 trillion benchmarked to it," he told the audience at the Inside ETFs Asia event organised in partnership with AsianInvestor. "China’s definitely at zero right now, but it will be 5% of that at full inclusion. The math – it’s a big number.”

And that’s just one index.

Once China's $12 trillion bond market is also hooked up to two other key global benchmarks – the JP Morgan Government Bond Index-Emerging Markets series (JPM GBI-EM) and the Citi World Government Bond Index (WGBI) – it could even disrupt funding for other emerging markets.

“What happens when the third-largest bond market in the world goes into [the JPM GBI-EM]? It’s one-third of the index. Think about the pressure that people would put on Mexico funding and Brazilian funding when the world’s third-largest bond market goes into [the JPM GBI-EM],” Ahern said.

Neither of the other two major index providers have so far indicated they have plans to include Chinese bonds, although Australia's government-owned Queensland Investment Corporation (QIC) has said it expects both indices to eventually add Chinese bonds in 2019 or 2020.

CREDIT MARKETS

The inclusion of Chinese government and policy bank bonds is only part of the story, given the untapped potential of Chinese corporate bonds, where illiquidity, legal uncertainties and a weak ratings system still stymie foreign investor interest. 

Government and policy bank bonds account for over 90% of Chinese fixed income holdings for overseas investors, Liao Qianyun, head of the index department at ChinaBond Pricing Center, said at the forum. 

But such a heavy safety-first bias is unlikely to continue indefinitely if Beijing continues to improve market access, fosters greater corporate transparency and reforms its regulatory and legal framework to ensure better default resolutions. 

One notable source of confusion holding back foreign investors, Li Lin, managing director of asset allocation strategy research at CreditEase Wealth Management, said on the same panel, are the vague endorsements or implicit guarantees from the government that often underpin bond pricing. 

So it can sometimes be hard for investors to figure out the relationship between the Chinese government and Chinese companies.

And as Mona Chung, head of ETF and Cross Asset at Ping An Asset Management, put it: “Investors tend to shy away from things they don’t understand.” 

However, the Chinese government is making an effort to reduce these kinds of guarantees to enable companies, whether private or state-owned, to be judged better on their own merits, the audience heard. 

“Overseas investors must go forward to have a look at the credit bond markets – this private sector bond market cannot be ignored by the investors,” ChinaBond’s Liao said.

BETTER EDUCATION

Another challenge for foreign investors is the sheer amount of research required to familiarise themselves with Chinese corporate bond issuers due to their sheer number.

“It’s very hard to do the research for each corporate issuer because there are more than 4,000 issuers in the China mainland market,” Liao said.

Overseas media narratives about China that focus on the negatives also muddy the waters for foreign investors, said KraneShares’ Ahern.

“There’s a big void to fill around quality China education and information – just reading the newspaper, I don’t think that’s a very good source,” he said.

For example, Chinese debt is one major area where overseas investors have misconceptions about the opportunities available. If there is debt, that means there’s a ledger, and if there’s a ledger that means there’s an asset offsetting liabilities, but many media narratives choose to focus on the liability rather than the asset, Ahern said.

“[That's] not saying that there aren’t risks, of course there are, but at the same time maybe some of the positives don’t receive quite as much attention,” he said.