Government bonds in China yield almost twice as much as US government bonds. However, at a time when the global pile of negative yielding bonds is in excess of $10 trillion, we are yet to witness an investor stampede.
Foreign investors transact more frequently than domestic investors, and thus their participation is key to a robust market. Thus it’s a positive for the market that foreign ownership has leapt in the past two years as the government opened up different exposure avenues – the Qualified Foreign Institutional Investor (QFII) and RMB QFII (RQFII) schemes, direct investment in China’s interbank bond market (CIBM Direct) and Bond Connect.
Yet at 2.2%, foreigners’ holdings are still tiny when compared with developed markets such as Japan (12.1%) and the US (28%) as well as such emerging markets as Indonesia (39%) and Malaysia (24%). Last year, China’s onshore bond market overtook Japan to become the second largest in the world in terms of bonds outstanding, behind the United States. And with its inclusion in all the major global bond indices all but inevitable, foreigners should increase their presence in China’s domestic bond market.
Poor liquidity is one of the reasons why global investors are taking a cautious approach.
“Liquidity consideration impacts our portfolio construction,” said Leonard Kwan, emerging markets fixed income portfolio manager at T. Rowe Price Group. “It limits our ability to take material positions in some of our larger strategies, which require a deeper market.”
The health of a bond market is more important to an economy, and its vibrancy more critical, than a booming stock market. Viewed differently, investors should worry much more when a bond market is in the doldrums than when stocks are down.
In China, bank finance is the primary source of lending. Since this is dominated by state-owned entities, pricing tends not to be market driven. Pricing of risk is more realistic in bond markets, which bring more efficient allocation of resources.
On-the-run liquidity has improved significantly with Beijing reducing the number of maturities, preferring to tap existing bonds. But off-the-run bonds become illiquid as they are squirreled away in hold-to-maturity portfolios. Deal ticket size is also linked to liquidity, as executing small deal sizes is a challenge.
“Large commercial banks hold roughly 60% of the outstanding government bond float as liquidity buffers on their balance sheet, and this greatly reduces bond market liquidity as a result,” said David Campbell, head of fixed income at industry body Asia Securities Industry & Financial Markets Association.
“The main pathway to improving bond market liquidity would be the deepening of the government bond futures market,” he said. “Allowing domestic commercial banks and foreign investors access would make futures more liquid. This in turn would allow liquidity providers to hedge their risk more efficiently, and therefore be more aggressive in price making for end investors.”
Such instruments also give investors a critical tool to adjust their market positioning, allowing them to express their views on duration and the shape of the yield curve.
And yet these shortcomings are deliberate because Beijing wants to discourage bond flipping – quick entry and exit of positions – and therefore avoid hot money inflows. It has drawn a lesson from Indonesian bond markets, where high foreign ownership has also made the rupiah volatile.
So as with other reforms in China, Beijing can transform its system with a flick of a switch – but it chooses not to move in haste.