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