Move signals new era for investors, may challenge Treasuries
The imminent debut in June of China's $8 trillion A-shares stock market in global benchmark indexes has garnered a lot of attention, but the inclusion of the country's $12 trillion bond market — starting 10 months later — could be far more consequential.
On March 23, Bloomberg Barclays Indices announced it will begin adding Chinese government bonds to its widely tracked Global Aggregate index in April 2019 and achieve a full target weighting of 5.5% by November 2020.
Some industry veterans predict China's admission to that club will effectively be a coming-out party for a market capable of quickly establishing itself as a safe-haven destination for yield-hungry investors around the world.
Over the longer term, they say, Chinese bonds will challenge U.S. Treasuries as the ballast of choice in turbulent times for institutional portfolios.
That's a bold prediction for a market that, outside of a select circle of central banks and sovereign wealth funds, has continued to be shunned by institutional investors as an off-benchmark bet difficult to access or hedge. Most managers peg foreign ownership of Chinese bonds at roughly 2% of the broader mainland market — or a little over $200 billion.
Fans of the market contend the flood of reform in China in recent years has left investors struggling to keep abreast of the opportunities offered now.
The rapid pace of regulatory change has made it challenging for people to "join all the dots together," said Hayden Briscoe, Hong Kong-based managing director and head of Asia-Pacific fixed income with UBS Asset Management.
Offshore investors remain "concerned about their ability to move capital in and out of the country," even as successive reforms in recent years have made it easy to do so, said Luc Froehlich, Singapore-based head of investment directing, Asian fixed income, with Fidelity International. Such concerns were justified in the past but not anymore, he said.
From virtually no entry, investors now enjoy considerable access to one of the largest bond markets in the world, agreed Manu George, a senior managing director, fixed income, with Schroders Investment Management in Singapore. Schroders launched a Hong Kong-domiciled strategy to invest in mainland bonds in December 2014 and a Luxembourg-domiciled strategy in June 2017, which combined now have $140 million in retail assets and $500 million in institutional assets, he said.
Investors desperate for income that the Global Aggregate index — with its heavy weightings in low-yielding Japanese and German government bonds — can't deliver now have been taking on more risk, seeking higher returns from emerging market bonds, Mr. Briscoe noted.
"What we're saying to clients is, 'why don't you think about Chinese government bonds? Firstly because" — with real yields that offer 150 basis points to 200 basis points of pickup over other developed market bonds — "it satisfies the income side," he said. And in terms of defensive characteristics, they act "exactly like U.S. Treasuries — when the S&P sells off, it's negatively correlated," he added.
Mr. Briscoe said the blank stares that suggestion elicited from offshore asset owners five years ago have given way to signs of growing interest — an evolution other managers report as well. Five years ago, "I had to defend the idea" of investing in China, but in the past three years more clients have become receptive — looking for reasons to invest, said Fidelity's Mr. Froehlich. Now a third phase is starting where people seem ready "to pull the trigger," he said.
Foreign share rising
Industry data suggest some investors are answering the call, with foreigners' share of the Chinese government bond sector rising to 5.6% by February from about 3.9% at the end of 2016, said Jason Pang, a Hong Kong-based vice president and portfolio manager on J.P. Morgan Asset Management (JPM)'s Asian fixed-income team.
Even so, government bond totals have grown more slowly than corporate and municipal bonds, sectors where the share of foreigners has been stable, likely leaving the foreign share of China's broader bond market in the 2% range, Fidelity's Mr. Froehlich said.
A large swath of investors remains skeptical about Chinese government bonds, but managers predict many will see a clearer, more compelling picture when they take a closer look in the runup to China's inclusion in the global index.
Bloomberg Barclays' move will force a broad range of investors to confront lingering prejudices about a Chinese market that has opened up considerably in recent years, said Jan Dehn, global head of research with London-based Ashmore Group PLC.
And the closer investors look, the more they're likely to appreciate the "amazingly attractive" attributes that market offers now, whether in terms of yield or diversification benefits, Mr. Dehn said.
Messrs. Dehn and Briscoe predict that within three to five years, most institutional investors will be placing 5% to 10% of their fixed-income allocations in Chinese bonds.
Within five years, "we'll have a completely different situation than we have today," with Chinese bonds in all of the major emerging markets and global indexes and well integrated in institutional portfolios globally, Mr. Dehn said.
UBS estimates that a 5% allocation by sovereign wealth funds, central banks and institutional investors across the board would mean inflows of roughly $3 trillion for Chinese bonds, Mr. Briscoe said.
Behaving like a safe haven
Market veterans say China is still technically a developing market, but in many respects its huge, fast-growing bond market should be classed with developed countries.
"The Chinese market is already behaving like a safe haven," even if it's likely to be a while before investor perceptions catch up with that fact, Mr. Dehn said. With its high yields, low correlations with other markets and low internal volatility, "the Chinese government bond market is already a serious competitor to established, developed safe-haven markets," he said.
That gives Chinese bonds an outsized role to play in local currency emerging markets bond portfolios, said Mr. Dehn. In periods of turbulence, investors have tended to flee emerging market bonds in favor of U.S. Treasuries, but going forward investors will be able to shift money into anchor allocations of Chinese bonds instead, making the asset class as a whole less volatile, he predicted.
Market veterans say the Chinese market's size and characteristics should support that safe-haven role, but only if the country's regulators are ready to take a hands-off approach during periods of market turbulence. In June 2015, for example, when a wild stock market rally gave way to a rout, regulators intervened aggressively to limit the market's decline.
In theory, China's market should emerge as a safe-haven option as it becomes more integrated with global markets, but that could depend on how open the country's regulators are to allowing investors to sell their bonds and convert out of China at times of stress, noted Aaron Costello, a Beijing-based managing director with investment consultant Cambridge Associates.
Mr. Briscoe said there's reason to expect methodical progress as the government pursues its long-term goal of restructuring China's global economic ties to secure better control in areas such as trade, food and energy security.
The latest example, he said, was the March 26 launch of renminbi-denominated oil contracts, a move that, together with China's inclusion in benchmark stock and bond indexes, will lead to a "sea change" in global asset allocation flows to Chinese securities, he said.
As "the largest oil importer in the world now," China is effectively borrowing from the playbook the U.S. employed 50 years ago when "they went down to the Saudis and said, 'we'll buy your oil as long as you settle it in dollars and recycle that back into Treasuries,'" Mr. Briscoe said. That, together with other renminbi-denominated commodity imports, should lift that recycling flow to as much as $900 billion a year, he said.
Ashmore's Mr. Dehn said the same logic — that the biggest kid on the block gets to write the rules — should eventually find Chinese government bonds displacing Treasuries as the paper against which all other paper is benchmarked, and the renminbi displacing the dollar as the predominant currency of global trade.
In 30 years or so, China's economy should be more than twice the size of the U.S. economy, with a far bigger bond market, and China's leaders will be methodical in leveraging that scale to become the world's financial hegemon, Mr. Dehn predicted. That status is "the single most valuable institution in global finance," he said.
China's growing presence in the global bond market is something even skeptical investors will need to take into account, Mr. Briscoe said. "We've been saying 'please pay attention to this because everything you currently own is going to get sold in this reweighting process,' and it's not a one-off. It's going to continue as the market continues to grow in size, and impact on the indexes," he said.