The playoff between China’s onshore and offshore bonds

China’s onshore and offshore fixed income securities present diverse opportunities for investors seeking exposure to a strengthening renminbi and the mainland’s increased inclusion in the global financial market.

The recovery in China’s onshore bond market has gained momentum, and prices still have room to climb. The recent move by the People’s Bank of China to cut required reserve ratio by 1% sends a strong signal that monetary conditions will be less restrictive compared with last year, says He Kai, the head of fixed income at Bosera Asset Management (International) (“Bosera International”).

“We have seen an improvement in liquidity starting from February in the onshore market, and this liquidity will likely benefit rates, in particular, high-quality credits, and to some degree higher yielding credits as well,” says He. Combined with a strengthening renminbi, investors should consider allocating a part of their portfolio to China onshore bonds.

Separately, as a result of rising treasury yield and concerns about heavy supplies from Chinese issuers, the offshore bond market has entered into a correction mode, which presents buying opportunities for investors, says Zhu Qi, a fund manager at Orient Asset Management (Hong Kong) Limited (“Orient”).

In this environment, we will be trading the onshore market while allocating to the offshore market strategically, say both fund managers.

Bosera International and Orient are co-managing the Bosera-Orient Sun Rise Greater China Bond Fund, a fixed income fund that invests in companies that have a majority of their income or revenue derived from Greater China. These companies may be based in or outside of Greater China. The fund may also invest up to 20% in each of convertible bonds and contingent convertible bonds and up to 30% in “Dim Sum” bonds.

“At the start, the fund will have a 50% allocation to onshore credits and the remaining 50% to offshore issues but as the market dynamic develops, this ratio may change significantly,” says Zhu. In the current market situation, the offshore China bond investment will focus on high-yield short-duration bonds and the onshore portion will likely be invested in high quality mid-to long-term duration bonds such as quasi-government bonds, according to both fund managers.

Offshore issuance surge
China introduced Bond Connect in July last year – a move considered by many as the most significant relaxation in the $12 trillion Chinese bond market, which is the world’s third- largest. Despite its launch, the Chinese corporates' onshore bond issuance slumped 32% to 5.7 trillion renminbi ($899.7 billion) in 2017—the first annual decline since 2010—as regulatory tightening pushed up funding costs. Some sectors, such as property,  faced specific restrictions on onshore issuance. These trends drove offshore issuance by Chinese corporates to a record high of $117.8 billion in 2017, up 123% year-on-year. Since the start of 2017, Chinese regulators have encouraged Chinese corporates to raise funds offshore.  In part, the growth of the market is driven by the financing needs of investment grade state-owned enterprises (SOEs) and private sector companies, as well as China’s growing presence in global credit indexes. 

In March, Bloomberg announced that it would include Chinese renminbi-denominated government and policy bank securities starting next year in the Bloomberg Barclays Global Aggregate Index. The inclusion will be phased-in over a 20-month period starting April 2019.

According to Bloomberg, Chinese onshore bonds are the top performers so far this year, among 70 markets in the Bloomberg Barclays Global Aggregate + China index, calculated in US dollars. Chinese notes in the Bloomberg index have climbed 6.2% this year, versus a gain of 4% in Japan’s bonds, the second-best performer in the gauge which measures dollar returns of investment grade notes in both developed and emerging markets. When removing the currency effect, Chinese debt is also the best performer, contributing positive returns to the index which registered a loss of 0.85%, according to Bloomberg.

China’s bonds bear low correlation with global higher risk assets such as equities and commodities and hence offers diversification benefits. “The good thing about this fund is that we do have the flexibility to switch from onshore to offshore and vice versa to make the best of our trading and investment ideas,” says Zhu. “The Fund, therefore, offers investors the most effective way to gain exposure to China fixed income.  

Both fund managers were not too concerned about the recent trade tensions between China and the US. “There might be a short-term impact, but I think both sides will find a solution that will be the least harmful to both parties. It will just be a process to reach that destination,” says He.