Investors turn cautious towards Chinese bonds after second month of Bond Connect
Some investors adopt a wait-and-see approach as the Bond Connect enters into its third month of operation
International investors’ buying of Chinese debt slowed in August, reflecting lingering concerns over the Bond Connect scheme, which is in the third month of its pilot programme allowing foreigners access to the mainland’s interbank bond markets from Hong Kong.
While many big banks took part in the first day of the launch of the Bond Connect on July 1 to show their support, helping boost volumes in the scheme’s debut month, other investors however remained in a wait-and-see mode.
Holdings of Chinese government and corporate bonds by foreign funds rose 15.33 billion yuan (US$2.34 billion) to 839.32 billion yuan in August, slowing from an increase of 37.8 billion yuan in July and 29 billion yuan in June, according to data from China Depository & Clearing Co. Inflows from foreign investors into China’s onshore bond market accounted for about 2 per cent of total onshore bonds outstanding.
China kicked off trading via the Bond Connect on July 3, the fourth cross-border bond trading programme, on top of the China Interbank Bond Market direct access scheme, the Qualified Foreign Institutional Investor and Renminbi Qualified Foreign Institutional Investor scheme.
Many foreigners are interested in China’s US$9.3 trillion bond market, which is the second biggest in the world after the US.
“To have a global portfolio without China is a huge imbalance,” according to Rajeev De Mello, head of Asian fixed income at Schroders.
Moreover, China’s debt market offers significantly higher returns than that of the advanced economies. The yield on the 10-year Chinese government bond has risen 64 basis points so far this year to 3.7 per cent while the yield on US treasuries with the same maturity has fallen 37 basis points to 2.1 per cent. German 10-year bonds are paying a yield of 0.4 per cent.
China’s yuan has also strengthened 3 per cent this year to 6.52 against the US dollar, enhancing the total return of onshore Chinese bond purchases. Yuan sentiment turned bullish after the currency broke above 6.70 last month, triggering expectations that the government was ensuring a yuan appreciation that was strong enough to attract capital inflows.
However overseas investors are still likely to stay subdued through the rest of the year.
Analysts said further catalysts were needed to attract new inflows from foreign investors. These include clarified tax rules, the opening of access to hedging instruments through the Bond Connect, and independent bond ratings from global credit rating agencies who have yet to set up onshore offices.
“Investors are still grappling with uncertainties. For instance, clarification in the tax arrangement is pivotal,” Sally Wong, chief executive at Hong Kong Investment Funds Association said.
Investors are asking for more clarity on whether the China Depository & Clearing and Shanghai Clearing will be the withholding tax agents, which would facilitate compliance issues for bond investors, Wong said.
Better access to hedging instruments is also required for foreigners to manage the risk of interest rates increases in China. So far, derivatives such as bond lending, bond forwards and forward rate agreements are accessible to foreigners via the China Interbank Bond Market direct access scheme but not through the Bond Connect.
Meanwhile, global ratings agencies setting up branches in China, expected to be operational by the new year, will likely help attract inflows into Chinese corporate bonds. Moody’s and Fitch currently have onshore offices through joint ventures with domestic rating agencies. But it is assumed that a stand-alone branch will foster more independent ratings.
About 96 per cent of foreign holdings are in high quality Chinese treasuries and policy bank bonds, while about 4 per cent are held in corporate bonds.
Confidence is the corporate debt market, which are riskier but offer higher yields than sovereign issues, should get a shot in the arm when global credit ratings agencies set up their onshore branches.
To further attract new funds, Chinese bonds need to be included among the major bond indexes of the world, such as JPMorgan’s main Government Bond Index - Emerging Markets index.
But Chinese authorities are likely to proceed cautiously to be able to closely monitor fund flows as China slowly integrates its capital markets with the world.
“I won’t read too much in the early-days inflows numbers. Interest is definitely there although much hand-holding of foreign investors is needed,” Wong said.