Digging deeper: China – the third-largest bond market in the world
For many years China’s US$13 trillion bond market was largely off-limits to foreign investors.[i] However, the Chinese authorities have implemented changes that make the market more investable. International investors and benchmark providers are reacting. For instance, the Bloomberg Barclays Global Aggregate Index added Chinese securities in April 2019[ii]. Today, the market is too important to ignore.
For investors willing to do their homework, Chinese bonds can offer attractive potential returns. They also provide a way to diversify portfolio risk. However, these opportunities come with risks which investors need to thoroughly understand. So what do investors need to know?
The key onshore markets are the China Interbank Bond Market (CIBM) and the Exchange Market. Over 98% of government bond transactions happen on the interbank market.[iii] Domestic financial institutions dominate bond ownership, with commercial banks owning around two-thirds of outstanding Chinese government bonds. Home-grown asset managers are increasing their share of market ownership. However, foreign investors are underrepresented, holding just 4% of the market.
The JPMorgan Government Bond Index-Emerging Markets Global Diversified Index, the predominant benchmark for investors in local-currency emerging market bonds, and the FTSE World Government Bond Index do not yet include Chinese bonds. We expect them to follow the lead of Bloomberg Barclays. We estimate this could attract between US$250 billion and US$350 billion from passive funds.
Years of isolation and a heavily managed currency mean that onshore bonds exhibit low correlation with other bond markets. They also offer an attractive yield pickup compared with similarly rated paper issued in developed markets.
Foreign investors still do not have the same market access as their local counterparts. However, it has never been easier to trade onshore Chinese bonds. Recent initiatives have slashed red tape and reduced restrictions for overseas investors. They now have direct access to CIBM and Bond Connect (a market-access scheme that provides access to the local market via Hong Kong).
Still, investors need to approach the market with caution. Potential risks include illiquidity, inadequate hedging options and an immature legal process for handling default and recovery.
New investors may be surprised by what they find when they research the market. Domestic credit rating agencies rarely award anything other than the top two ratings. In addition, this bond market had never experienced a default until 2014. Implicit government guarantees can still exert an influence on bond pricing.
The opening up of the world’s third-largest bond market (after the US and Japan) should be a cause for celebration. A fully functioning market will reduce Chinese companies’ reliance on bank loans. This will help fuel the next stage of the country’s growth. Foreign investors will play an important role in this process.
To learn more, read China’s Bond Market: ‘What and Why and When…’.
[i] BIS summary of debt securities outstanding as at Q4 2018 (17 June 2019).
[ii] Bloomberg, 31 January 2019
[iii] Wind newsletter (7 March 2017) China’s Government Bonds
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