Big China Story Seen by Pimco in Hands of Bond-Index Compilers

Fund managers say global markets are underestimating the impact on China of a small group of specialists: bond index compilers.

Pacific Investment Management Co. and AXA Investment Managers Asia Ltd. say the government’s opening up of its interbank debt market to foreign investors means the nation will be added to world benchmarks sooner than expected. While Citigroup Inc., Barclays Plc and JPMorgan Chase & Co. are being coy for now, brokerages are predicting inclusion will lead to a fivefold surge in foreign holdings of yuan debt by 2020.

“Market participants seem to have underestimated the chance for inclusion of China’s bond market into global indexes," said Aidan Yao, a senior economist at AXA Investment in Hong Kong. "As the world’s third-largest bond market, foreign investor interest in onshore debt is rising structurally because of the need for diversified global asset allocation.”

Inclusion would bring in funds just as China’s policy makers seek to stem the yuan’s losses and finance stimulus that will widen the budget deficit to a record 3 percent of gross domestic product this year. Standard Chartered Plc estimates that a 5-8 percent weighting in the Citigroup index may bring inflows of $100 billion to $160 billion from index-tracking fund managers alone. Foreign investors have been leaving China’s debt market at a record pace this year with the currency posting the biggest three-month decline through January since 1994.

“Chinese bonds are likely to be included in major bond market indexes sooner than expected -- probably in the next year or two," Luke Spajic, an emerging-market money manager at Pimco, wrote in a March 3 blog. He said in a Feb. 25 interview that, given the details of the market opening haven’t been announced, an increase in foreign access is “probably going to be a second half of the year story and certainly a big story for 2017.”

His comments came after the People’s Bank of China said on Feb. 24 that most types of overseas financial institutions will no longer need quotas to invest in the interbank bond market, which accounts for the bulk of debt in the nation. Also, in early February, China said fund managers approved under its Qualified Foreign Institutional Investor program won’t need to apply for allocations. Open-ended funds will be able to shift money in and out of the nation’s stocks on a daily basis.

Citi Welcome

As for debt, the Citi World Government Bond Index, JPMorgan Global Bond Index-Emerging Market, and Barclays Global Aggregate Index are the biggest that are likely to consider including Chinese securities, according to Standard Chartered. Citigroup Index LLC said on March 3 it welcomes the regulatory changes geared toward opening markets and it will continue to assess China’s eligibility, Barclays said it is “monitoring the situation” and JPMorgan declined to comment.

“Citi’s welcome message implies the possibility of the onshore market being included in the index,” according to Becky Liu, Hong Kong-based senior rates strategist at Standard Chartered. The Chinese market met requirements in terms of market size and credit quality long ago, and the latest policy changes on access have largely addressed the last hurdle, she said.

Market access to China bonds will be much easier than to Equities , said AXA’s Yao. Global index company MSCI Inc. responded to the easing of restriction on fund managers by saying that the steps were "significant" and that it will seek feedback from the international investment community before making a final decision on whether to include Chinese stocks in June. MSCI held off from adding China’s A shares to its benchmark indexes last year.

Foreign Investors

Foreign holdings of China’s onshore bonds declined for a third month in February to 541.3 billion yuan, extending a record drop of 49.6 billion yuan in January, China Central Depository & Clearing Co. data show. Foreign ownership of yuan bonds is likely to rise to 8-10 percent from less than 2 percent in the next five years, Deutsche Bank AG estimated, while Standard Chartered forecast an increase of up to 7 percent by 2020.

“There are a lot of technical details from currency conversion to fund repatriation rules waiting to be sorted out, so index providers are probably waiting for them before making any moves,” said Melody He, Hong Kong-based head of capital markets at CSOP Asset Management Ltd., which has $4 billion of assets under management and holds the biggest quota for investing offshore yuan back into the mainland.

Yield, Yuan

The yield on China’s benchmark 10-year sovereign note is heading for a ninth quarterly drop, retreating 169 basis points since the beginning of 2014 to 2.87 percent on Thursday. That’s much higher than the 1.86 percent yield in South Korea and 0.81 percent in Taiwan, which are both rated at Aa3, the same as China, by Moody’s Investors Service.

The yuan has declined 4.5 percent since an August devaluation, reaching a five-year low in January before central bank intervention helped pare some of the losses.

“A lot of people are concerned that yuan Volatility could lower the attractiveness of onshore bonds, but in the long run, if you look at other Asian markets, weakening currencies don’t necessarily lead to a drop of foreign holdings of local bonds,” said Xie Yaxuan, a Shenzhen-based economist at China Merchants Securities Co. “Global investors have varied fund sources, risk preference and investment style, it’s inappropriate to be overly bearish about China’s value in global asset allocation.”