What are the implications of China’s inclusion in the FTSE WGBI?
The Chinese bond market has historically been under-invested by international investors, but its tremendous pace of growth has propelled it to become the second largest in the world. As widely anticipated, FTSE Russell has recently made the decision to include China in its flagship World Government Bond Index (WGBI) from October 2021. This will be China’s third inclusion in a major global bond index, having already been included in J.P. Morgan and Bloomberg Barclays indices.
FTSE Russell rejected China on WGBI inclusion last year, but China has since significantly improved its fixed income market infrastructure, providing more access to foreign investors. Some of these improvements include enhanced secondary market liquidity, increased flexibility in foreign exchange and better post-trade settlement operations.
China’s bond market is valued at around USD 16trillion, but the level of ownership by international investors is still very low at around 3%. However, given the WGBI is known to have a much larger passive following than its J.P. Morgan and Bloomberg Barclays counterparts, this new catalyst could trigger a large inflow into the Chinese fixed income market and economy over the twelve-month phasing period.
The China Securities Regulatory Commission, in coordination with other local regulators, has also just announced reforms regarding China’s Qualified Foreign Institutional Investor (QFII) and RMB Qualified Institutional Investor (RQFII) programs. Reforms include allowing foreign investors to use commodity and financial futures as well as options, to invest in private investment funds and simplifying application and review procedures. These measures come as China seeks to further ease foreign access into its capital markets. The reformed qualified foreign investor program’s near-term impact on capital markets may be smaller, but it is an important step to enhance the appeal of China’s onshore market. Foreign investors looking to invest in China’s domestic market will now be able to use derivatives for hedging purposes, whereas previously this could only be done offshore in Hong Kong.
From the WGBI inclusion to the relaxing restrictions of China’s capital markets, we are seeing both local and global measures to make the Chinese economy more accessible. At a time when spreads of Chinese government bonds over developed market (DM) government bonds, such as the U.S., with same duration are nearing all-time highs, these developments should be welcome for those investors looking for yields. International investors will now have more reason to invest in the world’s second largest bond market and gain access to higher yield from the sovereign bonds that they have been marveling at from afar.
EXHIBIT 1: GLOBAL GOVERNMENT BONDS
Source: FactSet, J.P. Morgan Asset Management. Data reflect most recently available as of 28/09/20.
Investment implications
Given that many developed economies have adopted zero, or even negative, interest rates, investors are finding it difficult to diversify their portfolios using DM government bonds. The yield on Chinese government bonds, between 2.5-3% depending on tenor, provides an interesting alternative to international investors. With the FTSE WGBI inclusion serving as a new rationale for investing the Chinese bond market, increased inflows and greater attention from foreign investors will also provide more support to the performance of Chinese bonds.
Furthermore, the People’s Bank of China has also taken a more prudential approach to monetary policy than the rest of the world’s central banks. This, coupled with the low correlation between Chinese bonds and the global bond market, suggests that investors could find an added diversification benefit from allocating to CNY-denominated bonds.
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