Chinese government bond trade proves profitable for foreign fund managers using Bond Connect to take advantage of yield difference

Fund managers using the Bond Connect have been profiting from swapping dim sum bonds into higher-yielding onshore bonds
At US$15 trillion, the world’s second largest bond market gives investors in government bonds higher yield than those issued offshore

China economy

Georgina Lee

Published: 9:00am, 26 Feb 2021

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Fund managers have been profiting from a popular trade done via Hong Kong’s cross-border investment link into mainland China’s vast US$15 trillion bond market, taking advantage of the higher yields of onshore bonds as compared to their offshore equivalents.

The trade, carried out via the Bond Connect scheme, has been popular among managers active in China’s domestic bonds as well as so-called dim sum bonds – those issued in offshore yuan in Hong Kong. It comes as the Chinese bond market draws in record foreign investment, managers and bankers say.

In January alone, the onshore market recorded a net inflow of 120 billion yuan (US$18.6 billion) from foreign investors, up from an average of 70 to 80 billion yuan per month last year, according to bankers. Some of this influx has been channelled through the Bond Connect mechanism, which enables managers sitting in Hong Kong to access both markets with ease.

Investors watching the two markets are turning a profit by selling their dim sum bonds issued by the Chinese government, and then using the proceeds to buy the higher-yielding onshore equivalent via the Bond Connect link, managers say.

China’s central bank (pictured) and Hong Kong’s de facto central bank are working to expand the Bond Connect. Photo: EPA-EFE

The opportunity arises from the outperformance of dim sum government bonds. The limited size of the market – just US$9.5 billion in new issuances last year – often means demand for these bonds outstrips their supply. That compares to the far bigger onshore bond market, where new issuance last year totalled 48.5 trillion yuan (US$7.5 trillion), data from Refinitiv and the People’s Bank of China shows.

Also, “some investors are anticipating that the People’s Bank of China might begin to progressively tighten monetary conditions especially at times when positive Chinese economic data are announced,” said Ming Leap, an associate director of fixed income at HSBC Global Asset Management.

“The liquid onshore bond market is more reactive to these positive economic signals than the offshore, sending onshore yields higher.”

The yield differential is particularly evident in debt with a longer maturity. The average Chinese government bond yield in the dim sum bond market was 2.7 per cent, after the yields on 10-year notes dropped more than 20 basis points last year.

This compared to the 3.3 per cent paid by the onshore bond equivalent. A bond’s yield moves inversely to its price.

The trade makes sense for sovereign bonds only, because China’s Ministry of Finance is an active bond issuer in both the onshore and dim sum bond markets, said David Yim, regional head of capital markets for Greater China and North Asia at Standard Chartered. Chinese companies do not tend to sell bonds as frequently.

Also, when investors weigh up the returns of government bonds it is a straightforward comparison of the two markets’ interest rates, and credit risks would be considered very remote for Chinese sovereign issuers, said Yim.

“Investors will be hard-pressed to do a similar comparison for corporate bonds, because they also have to consider if the market is liquid enough for a possible exit if the company’s financial health, for example, suddenly deteriorates,” he said.

Attractive Chinese government bond yields compared to other sovereign bonds draw in foreign investors. Photo: Reuters

Foreign investors, who own just 2 per cent of China’s onshore bond market, will continue to pile into Chinese government bonds because of their attractive yields compared to US Treasuries, at 1.35 per cent for 10-year notes, or the negative yielding German bund.

“Chinese government bonds are a sweet spot for investors now,” said George Sun, head of global markets for Greater China at BNP Paribas, and this will continue to fuel interest in both the onshore and the dim sum market.

Since its launch in 2017, the Bond Connect has supported only the so-called northbound channel that gives foreign investors access to mainland China’s market via Hong Kong. But this is about to change, as the central banks of Hong Kong and China have said they will launch the southbound leg this year.

“Some foreign investors still prefer to access the market through the Bond Connect as they prefer the faster set-up and the governing jurisdiction of the Hong Kong court, given that their custodians and the trading platform remain in Hong Kong,” said Sun.

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