Bond disconnect: the trading link has missing pieces
As Bond Connect, a mutual market access scheme between mainland China and Hong Kong, goes live on Monday investors may hesitate to make the crossing given the absense of key tools such as interest rate hedging.
Much is at stake for Hong Kong and China. They are offering global investors faster and cheaper access to a bond market that is the world’s third largest bond, behind only the US and Japan, with about $9 trillion worth of bonds outstanding.
Only roughly 300 large institutional investors, mostly central banks and soveriegn wealth funds, have qualified to access China’s interbank bond market. They have to file an investment plan with the People’s Bank of China (PBoC) turning trading into a long, drawn out affair.
Now with Bond Connect, the barriers are coming down. The PBoC and the Hong Kong Monetary Authority said on Sunday that a trial operation of northbound trading under the Bond Connect starts on July 3. China Development Bank and Agriculture Development Bank of China said that their domestic benchmark bond issuance on July 3 and 4 will, for the first time ever, accept subscriptions from both domestic and global investors. China is hoping to attract a wide array of private sector investors.
Bond Connect could also bring China another step closer to inclusion in global bond indices. This will in turn pave the way for capital inflows to help offset China’s persistent capital outflows of around $10 billion to $20 billion a month. If China was included in all three of the most tracked bond indices, it could potentially see index flows of up to $250 billion over the next two years.
All of this, however, still hangs in the balance.
China does not have a great track record in attracting inflows – as shown by foreign investors’ lukewarm response to Beijing’s RMB Qualified Foreign Institutional Investor scheme, Stock Connect (Bond Connect’s equity equivalent) and the mutual recognition of funds.
Foreigners still hold only a very low share of China’s markets across asset classes: deposits and loans: 0.6%; equity: 0.8% and bonds: 1.9% in 2016.
Global index compilers will likely wait to see how China’s bond markets behave in times of stress before committing their index-trackers.
Investors should also hold fire until there is more convergence between onshore and offshore bond regulations in terms of tax, settlement, custody, credit ratings and accounting standards.
Without such alignment, inflows will likely be small initially, judging by the dismal volume of bond futures now traded on the Hong Kong Stock Exchange. Daily average volume was only 154 futures contracts between April 10 and May 16.
Missing pieces
Given Bond Connect is a joint project between the PBoC and the Hong Kong Monetary Authority, this scheme is certainly a step towards integrating China’s onshore bond market with offshore standards. But pieces are missing.
Investors will have to fund Bond Connect positions out of Hong Kong offshore renminbi pool (CNH), so they will be exposed to short-term spikes in CNH spreads.
Therefore CNH liquidity conditions are likely to tighten slightly in the coming weeks. The start of Stock Connect led to CNH liquidity withdrawal of Rmb45 billion and a sharp rise in CNH rates in late 2014 and early 2015.
Interest rate hedging with onshore interest rate swaps is not permitted under the Bond Connect scheme. Investments must be deemed to be mid-to-long term by the PBoC, so no flighty hedge funds.
China will initially allow only northbound flows; that is foreign institutional investors purchasing onshore China interbank bonds. Southbound trading has been delayed to an unspecified later date, presumably until capital outflow pressures ease up further.
Block trades are not possible under Bond Connect; this may pose a hurdle for real-money investors looking to conduct one sizeable trade and subsequently allocate the position into various
portfolios.
How to access the onshore repo market also remains uncertain under the existing account
structure.
The direct settlement counterparty for global investors using Bond Connect will be the Hong Kong Monetary Authority’s Central Moneymarkets Unit (CMU), which would conduct settlements through accounts opened at China Central Depository & Clearing and Shanghai Clearing House.
This negates the need for investors to set up an account with an onshore settlement agent, necessary under the current ways to access the China Interbank Bond Market. However foreign investors are exposed to counterparty risk with the Central Moneymarkets Unit (CMU), as their holdings of onshore bonds are held under a nominee structure.
Currently, the cash bond settlement cycle is limited to T+0 or T+1. T+2 may or may not happen at a later stage.
China's Tax Bureau has not issued a clarification so far on whether investments will be exempt from capital gains tax.
China needs to do better if it is to attract foreign private investors in the face of a weakening renminbi and following credit rating agency Moody’s downgrade of China’s long-term credit rating from Aa3 to Aa1, its first such downgrade in almost 30 years.