China's bond market largely untapped by foreign investors
At US$10.5 trillion, China’s bond market was the world's third largest as of September 2017, behind the US and Japan.
Given the size and growth trajectory of China’s onshore bond market, we believe there is scope for foreign investors to participate more heavily in it and for the asset class to potentially play a bigger role in global bond portfolios, says Morningstar's Singapore-based manager research analyst, Don Yew.
China’s bond market consists of both offshore (US-dollar and Chinese yuan CNH) denominated credits, and onshore credits (Chinese yuan CNY-denominated).
"The lion’s share of China’s bond market value is derived from the onshore market, which has grown from about US$4 trillion as of 31 Dec 2012, to $9.7 trillion as of 30 Sept 2017," says Yew.
He explains foreign investors have historically participated in China's bond market via the smaller offshore segment, which has higher penetration than the onshore equivalent, where foreign ownership remains low (around 3 per cent) because of limited accessibility in the past.
This is a phenomenon alluded to recently by Nikko Asset Management's Eng-Teck Tan, speaking about the opportunities within the Chinese stock market.
"Historically, a lot of investors had problems getting into the Chinese market because up to three years ago they were on, what we call, the qualified foreign institutional investors license.
Obtaining this license was a convoluted, cumbersome process that could take anywhere from a few weeks to a few months.
Similarly, Morningstar's Yew says the Chinese bond market is under-penetrated by foreign investors.
"Despite its colossal size relative to the offshore market, the total net assets within the RMB bond-onshore Morningstar Category (containing funds that invest mainly in CNY-denominated credits) is still just a fraction the size of the RMB bond and RMB high-yield bond categories combined.
Northbound and up
He alludes to the same Qualified Foreign Institutional Investor license as Nikko's Eng-Teck Tan, which is part of the Chinese government gradual process of increasing accessibility among foreign investors. This process started in 2003, with further changes in 2011 and most recently, in February 2016, when China's central bank announced the total elimination of quotas. This allows foreign banks, insurance companies, asset managers, and pension funds to invest in the interbank bond market with repatriation limits.
"The scheme commenced with "northbound" trading--allowing foreign investors to trade onshore Chinese bonds--while “southbound” trading--enabling Chinese investors to trade Hong Kong and overseas bonds--is yet to be announced.
Other plausible tailwinds for the asset class include:
1) Potential inclusion of onshore RMB bonds in global bond indexes, which could fuel inflows into passive funds. Both index providers estimated an aggregate of US$200 billion in inflows and expect China to account for approximately 5 per cent of the respective indexes upon inclusion.
2) In October 2016, the International Monetary Fund added the RMB to its basket of reserve currencies in its Special Drawing Rights basket, which will likely see the currency feature more prominently in global trade.
"We believe that the aforementioned developments in the onshore market will potentially drive greater accessibility and investor demand for the asset class.
"We consider the RMB bond, RMB-onshore, and RMB High-Yield Bond Morningstar Categories relatively nascent compared with their Asian and global bond peers, with majority of funds being launched only after 2011.
"As accessibility to the onshore bond market continues to improve, we are likely to see CNY-denominated debt play a bigger role in RMB bond funds, the majority of which still invest heavily in offshore CNH- and USD-denominated debt within their portfolios," Yew says.
He is also encouraged by global asset managers with existing Asian bond fund businesses--including JP Morgan, Schroders and Fidelity--building out dedicated onshore credit resources with wholly-owned foreign-owned enterprises. This is driven by their recognition of a need for more dedicated credit research within these markets, as they plan to invest more actively in the on-shore markets.
"As accessibility improves and asset managers dedicate more resources to the asset class, we believe that the continued growth of RMB bonds will broaden the investable universe for emerging-markets and global local-currency bond funds."
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Glenn Freeman is a senior editor at Morningstar.
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