The Emerging Emerging: Why China’s Onshore Bond Market Deserves a Look

Much has been made over MSCI’s announcement to incorporate China A shares in its Emerging Markets and ACWI indices beginning in June 2018. Indeed, this portends material fund flows, greater transparency, and a new investable universe for global institutional and retail market participants. But another shift is also underway: the continued opening of China’s onshore bond market to global investors and the upshot of anticipated inclusion in global fixed income indices. I want to paint a picture of why this market may just earn a spot in your portfolio over two posts. Today, we will cover some general descriptives —the five Ws, if you will. The follow up will identify the potential impact of benchmark inclusion (read: alpha).

The Basics

Bear with me, as there is not a great way to dress up a data dump. The Chinese onshore bond market is the third largest in the world, trailing only the United States and Japan. At a USD equivalent of $9.4 trillion, the onshore bond market dominates the stock market’s ~$7 trillion market capitalization, yet it has only realized 2-3% foreign ownership. Asset types are distributed across Government, Financial, and Non-financial corporations.

Issuance by the Chinese government, the People’s Bank of China, local governments, state policy banks (e.g. China Development Bank, the Agricultural Development Bank of China, and the Export-Import Bank of China), commercial banks and non-bank financial companies, and non-financial corporations (including state-owned and state-controlled enterprises) has led to a robust structure given the relative age of the market. Traded asset types include repos, CDs, MTNs, bills, notes, and bonds. The vast majority of the market trades OTC, similar to what is seen in the U.S. and EMEA today.

Now the question “But Pat, who can actually buy this stuff?” arises. In the past, foreign participation was severely restricted to investors under Qualified Foreign Institutional Investor and Renminbi Qualified Foreign Institutional Investor regulations. However, in March 2016, the market became more open as long-term foreign institutional investors (central banks, sovereign wealth funds, investment companies, etc.) were granted access without trading quotas or repatriation restrictions. Additional access via Bond Connect launched in July 2017, allowing foreign investors to access the market via Hong Kong.

Market Attractiveness

At the most basic level, the China onshore bond market looks, well, pretty much like most bond markets globally, minus a few different security types (it is still a young market, so I’m sure financial innovations like securitization, inflation-linked securities, capital structure evolution will arrive soon enough).

Why own it? Three reasons: yield premium, diversification benefits, and liquidity.

First, the pickup in yield is undeniable. Looking only at the 10-year (the premium is even more pronounced at the short end of the curve due to the flatter structure of the onshore curve), it is possible to capture 130 bps, 315 bps, and 356 bps over respective U.S., eurozone, and Japanese comparables. Keep in mind that the yuan is now also part of the IMF’s Special Drawing Rights basket, meaning that while that potential for currency volatility remains, it should be minimized—especially when you factor in carry and income for foreign investors.

(Click to zoom)

Second, look at the correlation matrix. Notice the low and negative correlations across asset classes that probably constitute a large part of your portfolio today? The onshore market is a natural diversification play—combining that with the yield advantage creates a very appealing story.

Finally, rehashing a few previous points assists in proving out the liquidity story. We have one of the largest markets in the world with a bare minimum of participants in an easing regulatory environment. Add to that the potential fund flows if/when the likes of JP Morgan, Citi, and Bloomberg Barclays opt to include the market in their global indices (estimates range from $150 billion to $300 billion depending on the source), robust issuance, and average daily trading volumes, and the liquidity picture looks bright.

Now that we have pulled back the curtain on the make-up and appeal of the China onshore bond market, as a next step we will drill down on what the continued opening of the market could mean in terms of alpha generation and risk mitigation. Keep an eye out for that analysis in part two of this series.