The expected surge of foreign funds flowing into China’s bond market, abetted by the inclusion of Chinese bonds in international indices, is spurring reforms in the world’s third largest bond market.
“When investors come in, the [Chinese] government will try to align its practices with global practices. That will make the market more healthy and give us more opportunities,” said Alex Leung, director of Hong Kong asset management firm Da Wan Asset Management, at the Fixed Income Leaders Summit in Hong Kong at the end of May.
Foreign fund flow into China through indices may spur better bond documentation in China, said Brad Gibson, co-head of Asia Pacific fixed income at AllianceBernstein. “Right now, my analysts can’t get enough data on Chinese bonds.”
In China, neither the transparency nor governance of the bond market is strong. Once all the international indices include China bonds, and sovereign wealth funds and central banks reach their intended allocations, "it’s a $3 trillion influx into China’s bond market over the long term," said Hayden Briscoe, Asia Pacific head of fixed income at UBS. “That is the single biggest capital market change in our lifetime.”
China’s $13 trillion bond market, the world’s third largest after Japan and the US, is going to double in five years, Briscoe predicts. Standalone Chinese bond allocations mainly come from Japan and EU accounts, because they are facing zero interest rates in their home markets. “It’s developed market indices, which makes it more important because it’s structural fund flow going to China which is sticky,” he added.
On April 1, China's renminbi-denominated government and policy bank securities were included in the Bloomberg Barclays Global Aggregate Index, a global fixed-income investment benchmark. Chinese bonds may be included in the FTSE World Government Bond Index as early as September. And China was put on a watchlist for the JP Morgan Emerging Markets Government Bond Index Global Diversified, another international bond benchmark, in 2016.
REFORMS
Reforms are already underway in China’s bond market, including a recent notice from the China Securities Regulatory Commission (CSRC). “The Notice on Providing Transfer and Settlement Services for Specific Listed Corporate Bonds” introduces transfer and settlement services for bonds for which payment obligations are not met. This will lead to a secondary market for distressed debt, which provides a market-based avenue for investors to price, liquidate or invest in distressed or defaulted assets.
This is positive for the development of China's bond market, because it provides investors with liquidity for distressed bonds, which would otherwise be suspended or delisted, according to ratings agency Moody’s.
China has seen a sharp pickup in corporate bond defaults over the past couple of years. In the first five months of this year, 66 corporate bonds totalling Rmb45.6 billion ($6.6 billion) have defaulted. This is more than the whole of any previous year except 2018, according to Chinese financial data provider Wind. Last year saw a record 125 corporate bonds totalling Rmb121 billion default.
A secondary market for distressed bonds will enhance the efficiency of debt restructuring and recovery for distressed bondholders, which will facilitate the development of the high-yield onshore market, Moody’s added.
“The move is a key milestone for the Chinese onshore bond market as the establishment of market-based and rule-based treatment of bond defaults will bring the market more closely aligned with global standards. We expect that these factors will further boost foreign investor participation in the onshore bond market,” the ratings agency said.
More reforms in China’s bond markets are in the offing, according to People’s Bank of China (PBOC) governor Yi Gang at a China bond index meeting in mid May in Beijing.
Yi called for regulations to protect investors, improved disclosure of bond information and better efficiency in the management of bond defaults. New regulations should be implemented to make China’s bond market more acceptable to international counterparts, he urged.
The Chinese central bank is considering scrapping official benchmark lending rates in a shift towards a more market-oriented mechanism. “Liberalisation of interest rates can be further explored,” Yi said.
China bond inclusion in indices will “wake up a lot of investors” outside Asia, said Ng Kheng Siang, Asia Pacific head of fixed income at State Street Global Advisors. “With index inclusion, when they see Asian fixed income grow so rapidly, they will have to take a serious look at the Asian market and make a decision on whether they want to include Asian fixed income.”
Fidelity International is tapping China’s onshore bond market for the sake of diversification, said Luc Froehlich, global head of investment directing in fixed income at Fidelity International. “For the moment, that is the most important factor.”
However, Briscoe warned, “As Western entities come in and trade credit in China, the volatility is going to go up. That is going to be a shock to Chinese banks.”
