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Aon Hewitt Retirement and Investment Blog

Onshore Chinese Bonds Enter the Global Bond Universe

China's large onshore bond market is becoming increasingly open and transparent and its entry into bond indices will have a big impact on index composition and, consequently, bond investing 
Historically, investors were largely only able to purchase US dollar-denominated bonds issued by the Chinese government and offshore bonds issued in renminbi ('dim sum' bonds). Now, however, the much larger domestic Chinese bond market has become accessible and is set to shake up bond investing.

China may have kept out of the headlines over the last year, but the country remains an important focus for investors. Concerns are broad-based and include the Chinese economic slowdown, renminbi (RMB) devaluation, high corporate debt levels, and high property prices. The potential market impact of these challenges should not be underestimated. Global equities dropped sharply in 2015 after the RMB's devaluation in a tentative move towards an ultimately free-floating exchange rate.

Then again, in January 2016, concern over China's slowdown, driven by the re-orientation of its economy towards domestic-led growth, caused further market panic. It is true that excesses have been allowed to build up in China. However, a key underlying factor behind these economic and market corrections is a momentous Chinese government drive to integrate China into the global economic system and to liberalize China's financial markets.

There is, also, another impact of this transition which is less well known but more positive for investors–a significant expansion of the global investment universe. MSCI, a market research-based index and analytics firm, is keeping equity investors on tenterhooks over when it will start to include mainland Chinese shares in its global indices, whilst the major bond index providers are already introducing Chinese onshore (or domestic) government bonds into some of their emerging and global local bond indices. They have been excluded from main bond benchmarks to date due to capital controls.

China’s bond market has developed quickly
The Chinese government’s dominant role in allocating credit has historically limited the size of the bond market relative to the size of the Chinese economy. China accounts for 15%[1] of global GDP but its outstanding bonds are a much lower proportion of the world bond total. That said, the Chinese bond market is still the third largest bond market and growing fast. As at the end of Q3 2016, the total value of outstanding bonds in China reached RMB 63 trillion (US$9.4 trillion), trailing only the US at US$38 trillion and Japan at US$13.9 trillion. Total Chinese bonds in issuance grew by 29%[2] in the last year.

The majority of Chinese bonds are traded onshore and have been off limits to most overseas investors up until 2017r. Overseas investors hold just 2.5% of Chinese onshore bonds. Foreign ownership is one of the lowest in any emerging debt market but the figure is set to grow with recent market reforms. Central banks around the world are expected to purchase more Chinese bonds in response to the RMB’s new world reserve status and overseas investors will also buy them now that they are more accessible.


Benchmark inclusion will result in an influx of global buyers
A major encouragement to global investors may be the inclusion of Chinese bonds in major local currency bond market indices. After the move to make the Chinese bond market more open in February 2016, Bloomberg and Citigroup have announced that they will add Chinese onshore government bonds to their local bond indices, although they have held back from introducing them into their flagship, more widely used, indices. Market uncertainties and the sheer size of the Chinese bond market have driven index providers into giving investors the choice as to when to move into Chinese bonds. Over time, however, fund inflows from overseas investors into Chinese bonds may be significant.

Unconstrained emerging indices could end up with Chinese bonds comprising as much as a third or more of the index, although popular benchmarks, such as J.P. Morgan’s GBI-EM Global Diversified Index, apply a maximum 10% weight to any one market. China's fast-growing onshore corporate bond market will also enter into local corporate emerging market indices in time, although local corporate debt remains a less developed area of emerging debt market investing.

Opportunity and risks
Chinese bonds have the potential to be return enhancing and diversifying for global bond portfolios. Diversification arises from the different economic cycle that China follows compared to developed markets and the still strong government influence in China’s economy. This expansion in the global investment opportunity set also provides bond managers with greater ability to add value, especially in unconstrained fund mandates.

Whilst Chinese onshore bond market access clearly is an exciting development in global investing, risks are high, particularly at this time of economic slowdown and transition in China. The government is aiming to shift the Chinese economy from a manufacturing, export-led orientation to a more consumer-led economy, whilst navigating an environment of slow growth. An abrupt end to China’s credit boom or property bubble and the risk of a significant RMB devaluation are at the forefront of investors’ concerns.

Summary
China’s globalization and the greater role of Chinese financial markets in global portfolios may be a major investment trend over the next decade. Chinese risks are currently elevated but, at the same time, we believe that market liberalization could provide a strategic opportunity to investors.

The uncertain outlook of the Chinese economy is deterring many investors from taking advantage of improved access to the Chinese onshore government bond market. In our discussions with active bond managers, they remain cautious. However, China’s onshore bond market is too big to ignore and could offer return and diversification prospects. Inclusion of these bonds, not just in emerging bond indices but also in global bond indices, may result in global investor inflows and support to Chinese bond returns. Investors should be checking with their managers that they are well positioned to navigate the complex set of risks and opportunities that Chinese onshore government bonds present. More details on this topic are in our full report on the Chinese bond market here.
 
Lucinda Downing is a Senior Investment Analyst in the Global Asset Allocation Team within Aon Hewitt Investment Consulting and is based in London, U.K.

Sources: Global Asset Allocation, Bank of America Merrill Lynch, Barclays Capital, Datastream. 
Click here for index descriptions.

[1] World Bank, December 2015
[2] All debt securities figures are from the Bank of International Settlements (BIS) and exclude loans


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