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Portfolio > Mutual Funds > Bond Funds

China's Bonds Are Ready to Join the World Stage

By David Millhouse

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(Bloomberg View) — Chinese President Xi Jinping will be in Hong Kong from June 29 to July 1 to attend a ceremony marking the 20th anniversary of the return of Hong Kong to China. All signs point to the likelihood that the official start date for the Hong Kong-China bond connect program will be announced during this visit — and it couldn’t come soon enough.

The first trading link for bonds between the mainland and Hong Kong will be the final catalyst to get China’s debt securities partially included in the major global indexes. Don’t underestimate the importance of that happening, as its significance would equal the decision last week by MSCI Inc. to include the nation’s domestic stocks in its benchmark indices.

Related: Mnuchin Says Ultra-Long Bond Program Wouldn’t Be a One-Off)

For example, the development of China’s bond market could be used to help finance strategic projects in Xi’s “One Belt, One Road” infrastructure program.With more than $10 trillion of bonds outstanding, China has the world’s third-largest fixed-income market. Yet foreign investors only account for about 2% of the market, as only a small number can actually access the securities via the Qualified Foreign Institutional Investor programs (known as QFII and Renminbi QFII) and the People’s Bank of China eligible-institutions program.

Here’s why the start of the connect program is urgent. The amount of corporate bond financings fell to a record low in May, coming in at a negative 217 billion yuan ($31.9 billion) as the amount of bonds that matured exceeded new offerings. Companies also canceled or postponed 372 planned bond sales valued at 340 billion yuan in the 12 months ended May 31, up from 287 billion in the prior 12-month period, according to data compiled by Bloomberg.

The weakness has largely been due to the China Banking Regulatory Commission’s crackdown on excessive leverage. Confirmation that the bond connect is about to be activated and bring imminent foreign capital could provide a timely boost to domestic sentiment.

Once begun, bond connect will enable central banks; monetary authorities; sovereign wealth funds; QFII and RQFII investors; and offshore financial institutions such as commercial banks, insurance companies, securities brokerages and fund management companies to invest in China’s bond market. In addition to opening the market to new investors, Hong Kong Exchange Chief Executive Officer Charles Li believes trading via the connect will be more efficient, allowing investors to deal directly with eligible onshore dealers via electronic platforms, rather than having to first go through an onshore bond settlement agent bank that negotiates with dealers on their behalf. That should enhance price discovery and liquidity, according to Li.

Furthermore, under bond connect there would be no requirement to specify an intended investment amount, which must be stated under the existing China Interbank Bond Market program. In an important and related move, the Chinese government in February opened its foreign-exchange derivatives market to foreign investors. This provides an avenue for foreign investors to hedge currency exposure in the bond market.

These measures, combined with the size of China’s bond market, will provide sufficient incentives for index providers to consider including the nation’s fixed-income securities in their respective indices in the next 12 months. That would see China’s influence in the world’s financial markets increase significantly. Preparations are already in place, with Citigroup announcing earlier this year that it plans to include Chinese domestic bonds in three sub-indices and Bloomberg Barclays stating that it would create new variants of its benchmarks to include China bonds. Global money managers should be preparing now for China to become a growing portion of their portfolios.

— Check out An Absent Chairman Is the Least of Anbang’s Problems on ThinkAdvisor.

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