Market Views: Is unifying China’s bond markets a game changer?
International institutional investors are paying increasing attention to China's $13 trillion bond market because of its sheer size, its inclusion in global indices and the yields it can offer. This is despite the fact that the asset class poses various issues, including capital controls, an underdeveloped derivatives market for hedging and liquidity concerns.
Bloomberg Barclays included Chinese treasury and policy bank bonds in its Global Aggregate Bond Index in April last year, while JP Morgan admitted Chinese treasury bonds to its flagship Local Currency Emerging Market Index in February. These inclusions are helping to attract flows into the mainland debt market.
And domestic regulators are working to widen market access. Having already scrapped the quota for its two prominent inbound investment schemes, the People’s Bank of China said on July 19 that it would unify the China interbank bond market (CIBM) and exchange bond market to facilitate monetary policy transmission and macroeconomic management. It did not specify a time frame for when this would happen.
Qualified investors will be allowed to buy and sell bonds traded in the other domestic market via the newly set-up 'connect' infrastructure.
As of end-2019, the volume of total outstanding bonds across the two markets was Rmb99.1 trillion ($143 billion), with interbank bonds representing Rmb86.4 trillion, or 87.2%, of that total.
AsianInvestor asked five market experts about the significance of this regulatory change and its implications for institutional investors.
The contributions have been edited for clarity and brevity.
Gregory Suen, head of China fixed income
APG Asset Management
The recent announcement to unify the onshore Chinese interbank and exchange bond markets is certainly a move in the right direction to enhance market access for foreign investors, although this move on its own is unlikely to significantly increase foreign inflows into the markets.
The reducing segregation of the two markets will allow wider access, as most foreign investors currently only have access to the interbank market through CIBM and Bond Connect because accessing the exchange market requires an additional application that may not be deemed worthwhile given the much smaller size of the exchange market.
However, this enhancement comes at a good time, when foreigners’ interest in [Chinese] credit is gradually increasing and as there are a good number of corporate issuers that only issue bonds through the exchange market. The exchange market focuses more on corporate bonds, ABS [asset-backed securities] and convertible bonds, which are areas where we see increasing foreign demand as investors expand their exposure from government bonds and policy bank bonds.
Also, from a trading perspective, the lot size in the exchange market is smaller, which could suit investors dipping their toes in credits that prefer to “start small and be more diversified”. Finally, this should improve liquidity for investors and reduce the liquidity premium in the exchange market to lower some issuers’ funding costs.
Anitza Nip, head of fixed income research for Asia
UBP
We reckon it is a logical step for the Chinese regulators to unify the two markets, though initially we may not see a significant pick-up in volume as the interbank bond market is a much larger market than the exchange bond market in terms of issuance and trading volume.
However, it is a symbolic move to improve the foundation of the platform by allowing a free flow of capital as well as enhancing the liquidity and transparency in terms of pricing for both markets. Investors will have easy access to both markets by opening just one account. For regulators, implementing macro controls and monetary policies will be more effective in the future.
Foreign institutional investors are expected to take some time to understand the mechanism and to increase participation, but in the long run the move will be constructive in attracting foreign investors’ interest in the China bond market.
However, the renminbi is not a fully convertible currency for the time being, and that will be one of the considerations for foreign investors looking to get involved in the China bond market. In addition, investors would like to understand more about liquidity risk, including whether there are sufficient market makers; monitoring of credit risks; the criteria used by the domestic rating agencies; and the restructuring process in the event of defaults.
Ben Luk, senior multi-asset strategist
State Street Global Markets
I believe integration between the interbank and exchange bond markets will be beneficial in the longer term in terms of attracting more market participants, boosting liquidity and reducing administrative procedures from an operational perspective, but we should not be overly excited that this is a game-changer.
The interbank market is far bigger than the exchange market and most institutional investors already trade via the former platform, whereas the exchange market is mostly dominated by brokerages and individuals. While integrating the two will increase the number of participants, which will likely boost liquidity, it will also create greater volatility due to the nature and investment horizon of retail versus institutional investors.
From a foreign investor perspective, increased liquidity is a definite plus, given how many commercial banks have a buy-and-hold maturity framework. But core issues remain including there being insufficient tools to fully hedge currency or bond exposure, and the lack of repo trading as an option through the connect.
Liam Spillane, head of emerging market debt
Aviva Investors
The People’s Bank of China’s move to unify its interbank and exchange bond markets is another step in China's wider effort to open the domestic bond market and push for further inclusion in global indices. So far, benchmark inclusions and the magnitude and persistence of flows into the bond market suggest the steps being taken are reassuring investors that reforms are bearing fruit.
Given their higher yield than risk-adjusted peers and significant diversification benefits, Chinese domestic bonds are an attractive strategic opportunity for international fixed income investors – and unification will make access easier.
The authorities have also taken many operational and practical steps to ensure that international investors can access the domestic bond market with confidence. They are also very aware of the sensitivity of those investors to currency stability and potential capital controls. This is why the Chinese authorities took steps to include the renminbi to the International Monetary Fund’s SDR basket and learned the lessons from the devaluation of the domestic currency devaluation in 2015.
This ultimately points towards their ambition to achieve stronger reserve currency status over the long term. But from investors’ point of view, there are further steps to be taken, such as full currency convertibility.
Low Guan Yi, chief investment officer for fixed income
Eastspring Investments
There have been multiple schemes launched and rapid changes implemented since 2013, all aimed at improving access for global investors to the China domestic bond market. Since 2019, foreign participation has markedly increased and at a consistent pace driven both by the increased weight in global bond indices as well as investor demand for diversification away from low-yielding G3 bond markets.
From the regulator’s perspective, participation by global institutional investors ensures a healthy and resilient domestic bond market by diversifying the pool of investors and ensuring relative valuation discipline. A vibrant domestic debt capital market is critical to power China’s economic growth, and we view the improved connection between the interbank and exchange bond market as a step further towards this policy aim.
Both domestic and offshore investors are currently limited to trading either the interbank or exchange market, depending on their fund setup, resulting in trading inefficiencies. That said, in addition to offering a yield pick-up [over other large bond markets], the China debt market offers room for active portfolio management, given the breadth of investment opportunities across government bonds, policy bank bonds and corporate issuers.