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Vanguard still wary of China bonds

As China makes strides toward winning inclusion for its local bonds in key global indexes, one of the world's biggest fund managers isn't yet ready to commit to following the revamped benchmarks.

"It's a big topic" at Vanguard Group Inc., which is "actively" and "aggressively" investigating whether to use benchmarks that include China or opt for indexes that exclude the country, said Jeffrey Johnson, head of fixed income at Vanguard Asia-Pacific.

How fund managers like Vanguard decide on the issue will help determine the magnitude of inflows to China's bonds in coming years. The country's authorities have been steadily opening up the market to foreigners in recent years, in part to help attract capital flows and reduce pressure on the yuan, which hit a decade low against the dollar on Tuesday.

Bloomberg LP earlier this year put China's yuan bonds on track for a phased-in inclusion in the Bloomberg Barclays Global Aggregate index in April, pending implementation of several reforms. Those changes are among a number of issues Vanguard is looking at, Mr. Johnson said in an interview Monday in Melbourne, Australia.

Assuming China does get included in the index in April, it could see about $5 billion of inflows a month as the weighting of Chinese securities in the gauge expands over time, Goldman Sachs Group (GS) estimates.

"Actual inflows may be more moderate since some investors may opt out for the Global Aggregate (ex-China) version," Danny Suwanapruti, an emerging-market strategist at Goldman in Singapore, wrote in an Oct. 29 note. One key issue is the relative lack of availability of government bonds to trade as local banks own almost two-thirds of that market and typically aren't active traders in the secondary market, he wrote.

Running a bond fund that tracks a benchmark index is more challenging than for stocks, because fixed-income products are less liquid, effectively requiring active management for what's often considered a "passive" investment. Any time a new country enters the global benchmark, Vanguard researches whether it can track the adjusted index without taking on trading costs that leave its funds performing at variance from the index.

"On the one hand, we look at it as a positive step" that China is approaching inclusion in the index, Mr. Johnson said. "We want the index to be broadly representative" of the universe of bonds, he said.

At the same time, China has only recently started opening up its domestic debt to overseas investors, and the appropriate infrastructure needs to be in place to allow Vanguard to transact without penalizing its investors, he said.

Alongside the points by Bloomberg Barclays index managers on reforms including the allowance of block trades, Vanguard is reviewing areas such as the information-technology and software infrastructure behind the trading of Chinese bonds.

"Can we access that market in a way that doesn't impose additional cost or risk of tracking error? We don't know what the answer is right now," Johnson said, adding the fund manager hopes to make a decision "in the next few months."

Apart from the index question, fund inflows to Chinese bonds have slowed recently as the country's yield advantage diminished relative to the U.S. and its currency weakened.

Bloomberg LP, which oversees Bloomberg Barclays indexes, is the parent of Bloomberg News.