In 2002, China took the first steps to liberalize its capital account allowing investment onshore through the Qualified Foreign Institutional Investor (QFII) scheme. 2017 marks the fifteenth anniversary of such initiatives and Bond Connect is the latest addition to onshore investment channels.
On the surface Bond Connect’s benefits may not be obvious, but the move improved China bond accessibility and brought the asset class much closer to global standards. As a result, the chance for China to be included in the major bond indices has gone up significantly and we believe this will provide an investment opportunity that has yet to be embraced.
The hidden criterion for index providers
For those less familiar, China’s capital account is partially closed and bond access has historically come in the form of applying though one of the following schemes: QFII, RQFII (Renminbi Qualified Foreign Institutional Investor) and CIBM (China Interbank Bond Market). Bond Connect is the latest addition with key features below (Figure 1).
Interestingly, index providers don’t just look at sovereign rating, liquidity, GDP and other macro data to decide if a country is included in an index. Most providers measure ease of access, which is an assessment of the ability to get in and out of the markets on an infrastructure-adjusted basis. This has been one of the critical hurdles for China’s index inclusion.
Global bond settlement conventions are usually T+2 (trade +2 business days) however, China’s T+0/T+1 have been a challenge for global investors given infrastructure, over-draft and time-zone limitations. With Bond Connect, Chinese government bonds now settle on a T+2 basis for foreigners, bringing China on par with other G10 bonds (including no repatriation limits and global custodial connectivity). China will likely be included in bond indices within the next 12 months.
The asset with limited allocation
Although China onshore bonds have been quickly adopted by Asia (Bond Connect registered CNY 7bn of purchases on day 1), European and North American investors have been slower to on-board the asset class. Allocations are extremely low due to a mix of access restrictions, lesser familiarity and index representation.
In the medium term, we believe it is almost a given for index inclusion at some point and investors will likely try to get ahead of the announcements. In addition to that, investors should also consider the benefits of accessing the China Bond market:
Lesser known asset class flexibility
Unlike other bond markets, the RMB Bond market offers a healthy mix of instruments for investors with distinct features between them (Figure 5).
Throughout the past years (Figure 6), we have witnessed periods where CNH short-dated paper yielded 1.5% to 8% whilst synthetic CNH bonds yielded 2% to 12% vs. China onshore (USD bonds hedged back to CNH). Asset class returns have also been varied indicating potential benefits of diversification.
In short, the opportunity set allows for yield enhancement and diversified capital gains. Investors need to consider a holistic approach towards investing into China – not just purely onshore bonds.
To sum it up, we’ve gone a long way from 2007 to date in terms of liberalization measures and Bond Connect has brought global standards to onshore China bonds. The opportunity set is robust and underinvested, which warrants a place in asset allocations considering bond index inclusion pressures should pick-up over time.