The $3 trillion inclusion

On 23 March 2018, Bloomberg Barclays announced[1] the inclusion of China onshore government bonds, issued by the Chinese government, and policy financial bonds, issued by the Chinese policy banks, into their Global Aggregate Index. Based on the current data, there are about $2.95 trillion (CNY18-19 trillion) domestic bonds that are eligible for the inclusion, which will be phased in for 20 months starting April 2019. The Global Aggregate Index is one of the major global bond indices along with Citi’s World Government Bond Index and JPM’s Government Bond Index Emerging Markets, and we expect the other two indices to follow suit later. This is a milestone in terms of the global recognition of the China bond market, as the inclusion complements the Chinese yuan as a reserve currency in the special drawing rights (SDR) basket. The inclusion into the Global Aggregate Index is conditional on mainly three factors (delivery vs. payment settlement, block trade allocation, and tax clarification) and we expect China to strive to satisfy these conditions in a timely manner.

Avenue to invest in China: Bond Connect

It has been almost a year since China announced[2] the establishment of Bond Connect, a system allowing foreign investors to transact domestic bonds onshore through Hong Kong. However, as of today, its adoption remains sluggish. Despite having 272 approved overseas investors[3], of which about 40-45% appears to have some Chinese background (such as Bank of China and China Construction Bank), the transactions that have gone through Bond Connect so far by our estimation are small, relative to other alternative channels including CIBM (China Interbank Bond Market) and RQFII (Renminbi Qualified Foreign Institutional Investor) which also allow foreign investors to transact domestic bonds. There is no periodical data disclosure on the official transaction amount for Bond Connect yet. We expect Chinese officials to actively tackle the technical issues on the system (such as delivery vs. payment settlement, which is critical for foreign investors, and block trade allocation) and once these are resolved, the usage of Bond Connect should pick up gradually.

Positive to offshore investors; negligible to onshore market

We believe the inclusion is positive for offshore investors as the Chinese domestic bonds offer better yields. China 5-year government bonds are currently at about 3.6%, which is wider than the current index yield of about 1.8%. The estimated weight of China bonds in the Global Aggregate Index is about 5.5%, the fourth highest weighting after USD, EUR and JPY. With a 20 month phase-in period, this implies a 27.5bp index weight of market impact per month, or $5-6 billion worth of passive purchases each month starting April 2019. For active managers, it may unlock a hidden source of alpha, given its low correlation with developed markets core rates. Looking to the longer-term, we expect more indices to include China domestic bonds and the range of onshore bonds included in global indices to not only cover treasury and policy bank bonds, but also local government and corporate bonds, which is a fast-growing part of the onshore bonds market. However, as the onshore market size is much larger, with more than $11 trillion outstanding, we see limited impact to the onshore market and domestic investors should continue to be the dominant driving force for the market dynamics.

[1] Bloomberg to Add China to the Bloomberg Barclays Global Aggregate Indices, Bloomberg, 23 March 2018 (link: https://www.bloomberg.com/company/announcements/bloomberg-add-china-bloomberg-barclays-global-aggregate-indices/)

[2] Joint Announcement of the People’s Bank of China and the Hong Kong Monetary Authority, Hong Kong Monetary Authority, 16 May 2017 (link: http://www.hkma.gov.hk/eng/key-information/press-releases/2017/20170516-5.shtml)

[3] Bond Connect (link: http://www.chinabondconnect.com/en/index.htm)