As China begins to open up, foreign investors are finding the onshore market more accessible. However, serious challenges and questions remain. Wei-Shen Wong reports from Shanghai and Beijing.

Global institutional investors are continuously on the lookout for more ways to expand the alpha portion of their portfolios, be it through the use of alternative datasets to help direct them to additional signals, or through tapping into new geographies and assets. 

With global economic activity predicted to slow down in 2019 according to economists, due to issues such as trade tensions between China and the US weighing on investor sentiment, getting that extra bit of alpha is only proving to be a more arduous task. 

The investable universe accessible to global investors has just expanded. Global investors looking to gain access to the onshore Chinese bond market now can do so albeit cautiously, through the Bloomberg Barclays Global Aggregate Index. 

On April 1, 2019, the index provider started the inclusion of some of China’s onshore bonds, otherwise known as renminbi (RMB)—or yuan-denominated (CNY) bonds.

Bloomberg will phase in some 350 Chinese government and policy bank bonds over the next 20 months, or by November 2020. Still, once fully included in the index, Chinese onshore bonds will account just over 6% of the index.

The inclusion of RMB-denominated bonds represents a move to connect foreign investors with the third-largest bond market in the world, standing at about $13 trillion according to the People’s Bank of China (PBoC)—the country’s central bank. 

Although this move has been encouraging for global investors looking to connect to China’s bond market, it is only one of the steps taken as part of China’s plan to open its economy, which have included trading links that allow investors to trade in its equities and bond markets. 

However, for China’s bond market to mature further, several details still need to be ironed out. These include improvements to infrastructure, liquidity, and legal frameworks, as well as hedging capabilities, to make it more of a “comfortable” space for foreign institutional investors to navigate.

China is a market that stands to offer some of the better returns globally, for example with its 10-year government bond currently yielding 3.43% as of April 23. Comparatively, the US 10-year government bond yields 2.58% as of the same date. 

Despite that, foreign ownership now only makes up just over 2% of the entire Chinese bond market. 

The deputy general manager of an onshore asset management firm agrees that the attractive yields are the reason that the attention on China’s bond market has been picking up. 

“Yields of US bonds are around 2.5% but here in China, bond yields are still relatively high, and fundamentally, the country’s GDP growth cross-sectionally is still high. Also, currency wise, the Chinese yuan is stable. So I think it’s more for foreign investors that are interested in getting exposure to China bonds rather than us actually having to sell [those bonds] to them, because the local market is huge,” he says. 

Despite the hype of accessing China’s onshore bond market, Bloomberg ensured that it also catered to investors that were not ready to get involved right away. Nick Gendron, head of fixed income indices at Bloomberg says, “We had to discuss with clients whether they wanted to go ahead and if they want CNY in their customized version of the Global Agg. There are a limited number of clients that wanted to take their approach of phasing in CNY and asked us to do that for them.” 

Options

There are currently four channels through which foreign institutions can trade in onshore bonds: qualified foreign institutional investor (QFII), RMB qualified foreign institutional investor (RQFII), China Interbank Bond Market Direct (CIBM) and Bond Connect. 

Bond Connect has gained significant interest since it was established in July 2017 by the PBoC and the Hong Kong Monetary Authority (HKMA), as it allowed overseas funds to trade onshore Chinese bonds through offshore infrastructure in Hong Kong. By the end of 2018, 1,186 foreign institutions participated in China’s bond market, of which 558 were through Bond Connect. It is quite a jump from the participation of 200 foreign institutions recorded at the end of October 2017. 

Unlike the other channels, Bond Connect allows investors to maintain their existing relationships with their global custodians.

However, this is only for cash bonds, and unlike the QFII/RQFII programs and CIBM, Bond Connect provides price discovery through an electronic trading platform. The other channels provide that through either phone or email inquiry to the onshore custodian and agent respectively. 

However, there is still room for improvement. A managing director at one of the major international banks operating under a universal banking model in Shanghai says while its clients want to use the Bond Connect channel, there are still a few issues there. 

“They only can use Tradeweb. Bloomberg is also connected, but I don’t think the platform is quite ready yet. For Tradeweb, the issue there is they have limited price providers. The PBoC has given licenses to only a few banks, and as a result, Bond Connect doesn’t have a price provider standard. We’re still waiting for Bloomberg, which will allow everyone who wants to be a market maker to do that. That will be the first start to get [the channel] strong,” he says. Bond Connect executives were not available for additional comment. 

Bloomberg was the second platform to be connected to Bond Connect at the end of 2018, enabling its terminal users to trade directly through its execution management system. It worked with the China Foreign Exchange Trading System (CFETS) to provide qualified investors with access to CIBM, becoming the first to offer access to the two most popular schemes used by foreign investors. 

MarketAxess is said to still be in discussions to be approved as a platform connected to Bond Connect. 

Tradeweb, which recently raised $1.1 billion in its initial public offering on Nasdaq, was the first offshore platform to link with the Bond Connect program. 

Li Renn Tsai, managing director and head of Asia at Tradeweb, says that prior challenges for foreign participants in the onshore bond market include the onboarding and registration processes, as well as due diligence and selection of onshore settlement agents. Also, challenges around reporting and restrictions on the size and direction of the investment activity have an impact, he adds. 

In the past, trading was executed manually, typically in a voice-brokered trading process, and in an unstructured manner. “All of these particularities meant that execution was susceptible to operational risk and very time-consuming and lacking in transparency and auditability,” Tsai says. 

Some of the enhancements to the infrastructure have happened since then include the tax exemption for overseas institutions. These developments have significantly reduced the barriers to entry that were hindering foreign investment into the Chinese domestic bond market. 

“When Bond Connect came on, it had attempted to address some of the issues that I mentioned, with the trading link and the settlement issue. The fully electronic trading link allows offshore investors to access and interact directly with onshore market-makers and the settlement link,” he says. 

Bond activity on Tradeweb has been steadily growing, with monthly average trading volumes in CNY cash bonds showing an increase of 230% on Tradeweb from July 2017 through to March 2019. Tradeweb reached nearly $1 billion per day in February 2019. 

Further proof of the progress that Bond Connect has made is by the number of registered investors on the platform. As of March 2019, that figure has climbed to 711 from 558 in January. Sources spoken to for this story agree that this will only continue to increase with time.

Tradeweb is working with CFETS to introduce pre-trade indicative prices, as one of the incoming features for Bond Connect. Onshore dealers will be able to publish indicative prices on bonds, which Tsai says would give offshore investors a better view of the liquidity of the different instruments they might be interested in trading. 

“This pre-trade information provided by the dealers is a first for Bond Connect. The data may have been previously available in unstructured forms, such as messages, but Tradeweb will put all of this together, so the onshore dealers will now have a channel to stream their indicative prices to offshore investors directly,” he says.

One of the features it recently introduced is the block-trading functionality that allows offshore investors to execute on behalf of multiple funds in one block transaction on its platform. “Also, we allow clients to take advantage of straight-through processing benefits through our integration with order management systems,” he says.

Another challenge trading onshore bonds via Bond Connect presents is that investors are not able to hedge in the local market. “If you think about asset managers investing in the China market, they would need to do foreign exchange (FX) trading and risk hedging, but they don’t have access to the local FX and risk market. They don’t have access to the local market—for example, to bond futures. This is the most important issue asset managers need to consider when using the Bond Connect channel,” the managing director at the bank adds. 

However, foreign investors can hedge in the onshore market using the CIBM channel instead. 

Investors under the QFII and RQFII programs allow foreign institutional investors to invest in China’s onshore equities and bonds markets within a defined quota. These two programs will shortly merge, as proposed by the China Securities and Regulatory Commission (CSRC) as part of a move to ease access for foreign institutions. The CSRC also suggested broadening their investment scope to include derivatives, bond repurchases, and private funds. 

Christophe Roupie, head of EMEA and APAC at MarketAxess, says cost synergies and efficiency gains will drive the ultimate model.

“Most global investors are coming under pressure from fees or performance targets, while the debate around active versus passive management has shifted some of the focus onto execution costs. These drivers will influence the future model, but ultimately the most effective technology solution will win. Dealers are also seeking scale, meaning it is likely that Bond Connect will evolve as bank business models changes, alongside buy-side AUM fee compression,” he says. 

Vippy Wong, a partner at Hong Kong-based consulting firm Quinlan & Associates, says there will be some consolidation of these channels further down the road. It will make it simpler for international investors to access different investments onshore in the Chinese market, she says. 

“Institutions we speak to ask if they should access the market through QFII or RQFII or bond connect. You’ll likely see some consolidation of these channels in the immediate term. However, in the longer term, we are likely to see full and open access for foreign investors like most international financial markets,” she says. 

The Risk Factor

Trading platforms and channels aside, diving into China’s onshore bond market remains as a cautionary exercise due in part to the level of uncertainty brought about by the lack of global credit ratings agencies there.

It’s one reason why Bloomberg, for example, is only adding Chinese government bonds (CGBs) and policy bank bonds, which are relatively risk-free.

Bond Connect users can trade all types of bond securities on the China interbank bond market, including treasury bonds, local government bonds, central bank paper, financial bonds, corporate credit bonds, and commercial paper, as well as asset-backed securities. 

Last year, 45 Chinese corporates defaulted on a total of 117 bonds with a principal amount totaling $16.3 billion, according to a report by ratings agency Fitch Ratings. 

So, while foreign institutional investors’ interests are piqued, this remains an area of concern for them, according to a vice president of global markets at another bank based in Shanghai. 

Some of the questions that the bank gets asked by clients are on the methodologies of local ratings agencies. They have, in the past, been accused of rating onshore bonds too highly. Some of these concerns have centered, in particular, on corporate names.

“The recent credit default events are also a big concern, and we have some names that defaulted that were rated AAA by local agencies. And even after the bonds issued defaulted, the rating is still kept at AAA. So, offshore investors are very confused. Why is this? What is the mechanism for local credit rating agencies and how do onshore investors look at their balance sheets—they ask things like that,” the vice president of the bank in Shanghai says. 

However, local asset managers tend not to pay too much attention to these ratings. The deputy general manager at the onshore asset management firm explains that this is in part due to the implicit guarantees that the Chinese government has provided on any potential defaults. 

“A large majority of onshore bonds get rated AA, which is classified as investment grade and high-yield. It’s probably more like a BBB,” the manager at the onshore asset management firm says.

However, the Chinese government has made some efforts in breaking down those guarantees, by bringing in new asset management regulations. In April 2018, the PBoC issued its Guidance Opinions Concerning Standardization of Asset Management Operations by Financial Institutions, detailing how it will tackle the matter. One of the main requirements of the regulation is that financial institutions can no longer commit to guarantees for principal or yields of products, or bail out any struggling products. 

That said, having been long-ingrained within the Chinese system, it isn’t something that can change overnight. 

“So, it doesn’t really matter who issues the bond, because local bondholders simply don’t care due to the implicit guarantee of the government. That’s why the government is trying to break this image of implicit guarantees. But retail investors are used to having that guarantee for about 20 years already, and now they want to start taking it away? Good luck,” the deputy general manager says.  

The distrust foreign institutions have for domestic credit ratings is why PBoC’s approval for S&P Global Ratings’ Beijing-based operations to start rating onshore bonds was praised. However, S&P has yet to make any announcements on the onshore bonds that it will be covering. 

MarketAxess’ Roupie says creditworthiness will continue to be a major concern for global investors. “As it stands, four out of five local issuers are rated AA or more by Chinese domestic rating agencies. The internalization of the Chinese bond market will put additional pressure on domestic issuers to provide accurate financial disclosures, helping to raise industry standards in the process. Global investors have a huge amount to learn about domestic Chinese issuers, and even though it’s early days, S&P Global will help to bridge the gap,” he says. 

However, at the moment, it’s only the domestic agencies that can provide ratings, and there is no benchmark to what is high or low, says Quinlan’s Wong. 

“Once you have the foreign agencies in the market, who obviously adhere to global standards with how they rate bonds, there’s a clear understanding of how it’s done—including how that compares to the way they rate bonds in other jurisdictions. Greater competition will provide further additional benchmarks as to whether the ratings from the domestic Chinese agencies are too high or too low,” she adds. 

It is uncertain if onshore corporates would be willing to share their data with S&P, which means S&P might have to source the data publicly or perhaps conduct onsite visits. “I think they might be doing some credit rating for asset-backed securities issued by onshore firms like car loans, for example,” the vice president for the bank says.  

The other two well-known global rating firms—Moody’s Investors Service and Fitch Ratings—which both have wholly owned subsidiaries in China, are still waiting for approvals from regulators to start operations at press time. 

As to how S&P coming in will impact onshore investors, she says onshore banks have their internal rating mechanisms in place. “As long as they have credit facilities for these companies, they can buy their bonds issued by these companies. So, they don’t really care about what the international rating is for the issuer. It’s really only to appease global investors. The local domestic investor wouldn’t care at all about this,” she says. 

One thing is for sure, though; if more international agencies receive approval from regulators to start rating onshore bonds, the competition will lead to better price discovery, which in turn will lead to better transparency in the bond market. 

Scratching the Surface

In a presentation during the RMB Fixed Income and Currency Pan-Asian Conference hosted by the Hong Kong Exchanges and Clearing (HKEx), Zhihuan E, chief economist at Bank of China (Hong Kong), noted that foreign investors are increasing their allocations in onshore bonds. In early 2014, bonds accounted for 13% of RMB assets held by overseas investors, which jumped to 35% by the end of 2018. 

Even as more offshore investors are either starting to add or increase their allocation of onshore bonds to their portfolios, it comes as a stark reminder that foreign ownership of onshore bonds is still only 2% of the entire Chinese bond market. 

Olivier d’Assier, head of applied research for APAC at risk management technology provider Axioma, says it’s good that onshore bonds are now in the same league as the global universe of bonds. “[The China bond market] is going to be the largest in the world someday. The problem in China is, because the bond market is fairly new or recent, it’s hard to establish yield curves. There are not enough dots to do that. Not every sector has enough bonds in it to establish a baseline spread for that sector or rating. The curves are not well established yet. There are some holes maybe, there are no five-year bonds, or it’s hard to establish risk premiums or spreads,” he says.

The bulk of bonds in China are still traded over the counter, but that is changing with programs like Bond Connect encouraging electronic trading instead. However, just looking at government and policy bonds does not make up for the problem that there are too many holes in the curves to establish spreads with credibility. “There are not enough peers in the rating sector with the maturity to deal with it,” he says.

Just over half a year ago, Axioma bought onshore bond data and is “crunching those numbers” to establish yield curves. “In China there are a lot of holes and most of the curves that are established are based on cluster curves. These are based on available ratings or sectors but sometimes we can’t get as granular as we’d like because there’s not enough bonds. So we create cluster curves around sectors or ratings and look at a specific issuer, decompose it and then look at how it’s trading against its peer. That’s the only approach you can use right now because of all the holes along the various yield curves. It’s like trying to complete a half-broken Rubik’s Cube. If you’re missing half the pieces, you’d have to just try imaging and extrapolate it,” d’Assier says.

With China taking a seemingly more proactive stance in opening up its markets to the rest of the world, foreign investors will also still have to bear in mind that a significant factor—Chinese regulators—weighs pretty heavily on its markets.

Dealing with regulators is an interesting concept in China. It seems as if any financial contract is subordinate to the regulator’s ruling, according to the deputy general manager of a local asset management firm. 

“Regulation in China is hugely different from the ‘free world,’ because here, everything is regulated by the CSRC, explicitly or implicitly. Anytime you want to make a move, the first thing you’d do is talk with the regulators. The CSRC becomes the go-to person rather than an already defined contract,” he says.

While it’s true that Chinese regulators tend to intervene in the market quite drastically—and often without prior warning—d’Assier says most global investors have started to consider having some exposure to the market. “If you look at the inclusion, it’s being done progressively and slowly. Most people who have a global portfolio will have 1% or 2% of exposure to the RMB, and the biggest part of the inflows are yet to come. That will only come when China starts opening up even more,” he adds.

The addition of onshore bonds to the Global Agg index is a positive step, says d’Assier but it is still “tiny” compared with other nations, and yet, the potential is enormous. 

“There is still a good chunk of the market that still needs to be looked at in the future,” adds Bloomberg’s Gendron.