China bonds gain weight

The fast view

• Since joining the flagship suite of EMD indices earlier this year, China’s bond market has attracted another c$90bn of bond inflows. Its forthcoming inclusion in the FTSE Russell World Government Bond Index (WGBI) is expected to propel the market to another level.
• Just announced overnight, from October 2021 onwards, Chinese government bonds will be included in the WGBI. This is likely to result in further passive inflows of c$120bn into this increasingly mainstream market.
• Already larger than both the German bund market and UK gilt market, China fixed income is attracting growing interest from investors.
• With its diversification characteristics and attractive yields, as well as improving accessibility, this is an increasingly important asset class for investors’ portfolios.

Widening and deepening

The onshore China bond market – discussed in this paper - has seen a significant broadening and deepening of issuance in recent years to  become the second largest bond market globally, with a market capitalisation exceeding that of both German bunds and UK gilts. Index inclusions to flagship indices in 2019 and earlier this year have catalysed acceptance of this asset class into the investment mainstream.

An increasingly accessible source of yield

China bonds provide investors with a diversified source of potential return and a significant yield premium compared with other asset classes. The decision by FTSE Russell to include China bonds in the WGBI is expected to inject another c$120bn of passive investment flows into China over the next two-to-three years. It also continues the mainstreaming of this asset class, evidenced by the country’s inclusion in other major bond indices such as the Bloomberg Barclays Global Aggregate Bond Index and the JP Morgan GBI EM Global Diversified Index. By including China, FTSE Russell acknowledged that ‘Chinese authorities have implemented significant improvements to the fixed income market infrastructure, facilitating easier participation by international investors. These market enhancements include: improving secondary market bond liquidity; enhancing the foreign exchange market structure; and developing global settlement and custody processes’. 

Based on current projections, China’s eventual weight in the WGBI is expected to be c5.7%; similar to that of German bunds and above that of UK gilts.

A valuable portfolio diversifier

In addition to these index-related ‘passive’ investment flows, we expect the trend of increasing discretionary investor allocations to continue apace, leading to even more flows into China. Offering an attractive risk premium, China bonds are generally less volatile than their global peers, while delivering a superior yield. They are also highly diversifying, reflecting the greater importance of domestic factors on the country’s growth and inflation dynamics, in contrast to other smaller emerging markets which may be influenced more by global trends. These attractive characteristics are rapidly gaining the attention of the global investment community.

Fundamentally solid

With substantial foreign currency reserves and low external debt requirements, China should not be viewed as a conventional emerging market. We contend that China bonds, as an asset class, behave more like developed market fixed income with potentially safe-haven features during periods of market stress. In a yield-starved world, this is an asset class that asset managers and investors alike simply cannot ignore.