Bonds prove irresistible to foreign funds

Dec-end holdings of interbank paper at $628b; CGBs, quasi-sovereigns shine

A stable renminbi exchange rate and higher yields have been attracting overseas institutions to Chinese bonds, pushing offshore holdings to new highs, according to central bank data.

The Shanghai head office of the People's Bank of China on Monday said that overseas institutions held 4 trillion yuan ($628 billion) of China's interbank bonds by the end of December, up 23 percent year-on-year.

Chinese government bond or CGB holdings by offshore investors reached a record 2.45 trillion yuan at the end of December, up nearly 31 percent year-on-year. Holdings of quasi-sovereign bonds issued by China's policy banks also jumped 18 percent year-on-year to a record 1.08 trillion yuan by the end of December.

By the end of last year, there were 1,016 offshore institutions trading in China's interbank bonds. Six of them were newcomers that started trading in December.

The bond connect program linking the Chinese mainland and Hong Kong bond markets, which was launched in July 2017, proved to be the major investment channel. Some 728 overseas institutions opted for this channel last year, according to data in the public domain.

The relatively lower correlation between the Chinese and developed economies' bonds markets has prompted offshore investors to increase their allocation to China, in order to spread their risk across a diverse portfolio.

The stable renminbi exchange rate has also increased the appeal of renminbi assets, said Zhong Haidan, senior investment manager at investment company Invesco.

The inclusion of Chinese bonds in major international indexes has increased global investors' passive allocation of Chinese bonds. For instance, CGBs were included in FTSE Russell's World Government Bond Index in late October.

China bonds were included in the Bloomberg Barclays Global Aggregate Index in April 2019 and JPMorgan's GBI-EM Index in February 2020.

The momentum will likely continue this year, with up to $125 billion in foreign capital expected to flow into the Chinese bond market, thanks to their inclusion in major indexes, said Xia Yinyin, credit research analyst with UBS Securities.

The Chinese bond market stands out from the global fixed income market that reported sluggish returns, said Wang Qian, Asia-Pacific chief economist at US-based Vanguard Investment Strategy Group. The average yield of the Chinese bond market is expected to be 3.1 percent in the next decade, much higher than the estimated 1.8 percent for other markets, she said.

Luca Paolini, chief strategist at Geneva-headquartered Pictet Asset Management, agreed that there would be little value outside China when it comes to fixed income investment this year.

As the global economy recovers from the COVID-related recession, supply bottlenecks and rising energy and commodity prices are pushing inflation higher, driving major developed and emerging markets' central banks to tighten their monetary policies.

Markets are pricing in the possibility that central banks in the United States, the eurozone and the United Kingdom will likely raise interest rates at least once by the end of this year. So, government bonds continue to look very vulnerable and unlikely to deliver positive returns, said Paolini.

But, as an asset class, CGBs are "one of the few bright spots" as China's central bank is easing its monetary policy. For instance, the PBOC lowered the reserve requirement ratio in mid-December, bucking the global trend, he said.

"Inflation remains under control and we do not expect it to exceed the PBOC's 3 percent target, thanks to more muted demand than elsewhere and a strong renminbi. CGB yields are expected to hover around 3 percent this year, so they remain attractive compared to what's on offer elsewhere," Paolini said.