Foreign hedge funds eye China bond market ahead of index inclusion curve

Foreign hedge funds are injecting liquidity and sophistication into Chinese bond markets, seeking opportunity for return before the full Bloomberg index inclusion comes into effect

As China continues to open its US$13 trillion fixed income market to international investors, over the past few years foreign hedge funds (HF) have been ramping up their level of activity to get exposure to onshore China bonds.

This process is bringing change to the Chinese market, with a combination of the liquidity brought by HF and the diversity of the foreign investors gradually improving the China bond ecosystem.  

“A lot of hedge funds have positioned it (China bond market). We have seen many hedge fund clients doing this already. Now almost all types of financial institutions are already participating in this market,” says Ryan Chan, head of Greater China cross structuring group, global markets for Asia Pacific at Societe Generale, in an interview with The Asset.

On April 1, Bloomberg added China onshore renminbi-denominated bonds into its Bloomberg Barclays Global Aggregate Index, signifying a further opening up of China’s bond market to global investors. The index inclusion will be phased in over a 20-month period, starting in April 2019, with a scaling factor of 5%, and increasing in 5% increments each month. 

According to China Foreign Exchange Trade System, the total notional value of cash bonds held at China’s interbank bond market on April 1 was 759.9 billion yuan (US$113.29 billion), representing a 28% increase on the daily average value during 2018. Foreign investors contributed 18.5 billion yuan, accounting for 2.4% of the total.

Ken Hu, chief investment officer, fixed income, Asia Pacific at Invesco, expects about US$1.2 trillion worth of inflows over the next five years.

While the opening up of China's domestic market dates back to 2002 (when QFII was introduced), the foreign inflow has accelerated substantially since the introduction of the CIBM direct scheme in 2016 and also Bond Connect in 2017. According to Chan, the onshore bond market is still skewed towards high-quality investors, and he says foreign hedge funds remain less significant compared to the impact of high-quality investors.

“But hedge funds introduce liquidity into the market, which is a healthy phenomenon,” says Chan. “It will also help develop the Chinese bond market as the regulators would like to see the participation of these sophisticated investors in various part of the onshore bond market.”

Though not obliged to track indices, foreign HF are nevertheless looking to move ahead of the curve before the full index inclusion. “They (HF) have a slightly different view because this is almost an opportunity trade. They know that there will be huge capital going into the market, which makes for a wonderful position for them to make money,” says Chan.

In a bid to magnify their investment returns, hedge funds also use leverage, facilitated by investment banks. In addition, the absolute onshore yield is still relatively more attractive than other bond markets, especially given the recent inversion of the yield curve in the US. Currently, most foreign hedge funds still focus on China government bonds or China Development Bank bonds.

“There are cases where some hedge funds have already invested in the credit bond markets. They can pick opportunities that they are comfortable with,” says Chan.

“As investors increasingly participate in and understand better the Chinese onshore bond market, they will feel more comfortable increasing their renminbi asset allocations, and expanding their investments to other credit bonds like municipal bonds, corporate bonds and ABS,” says Ivan Chung, head of Greater China credit research & analysis, Moody’s Investors Service.

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