Bond Connect: Game-Changer or Mere Hype?
(Beijing) — Allowing overseas investors to trade Chinese onshore bonds via Hong Kong, probably starting later this year, is Beijing’s latest attempt to rev up its massive yet illiquid bond market while further integrating its financial markets with the former British colony.
This is the first leg of a program formally known as Bond Connect. Within two years or so, the program will allow mutual access between China and Hong Kong bond markets, according to the operator of the Hong Kong Stock Exchange. Bond Connect is seen as a sequel to Hong Kong’s stock-trading links with Shanghai and Shenzhen, or Stock Connect, launched in 2014 and 2016 respectively.
“Given the vast differences between the structure of the bond markets in China and the developed economies, Bond Connect is a practical solution to bring foreign investors and Chinese issuers together,” Charles Li, CEO of Hong Kong Exchanges and Clearing Ltd., said Thursday.
Will Bond Connect get foreign investors keen as Beijing has hoped?
China, the world’s third-largest bond market by value of outstanding bonds, has an allure to investors who are baffled by razor-thin yields elsewhere or who need yuan assets in their portfolios. However, foreign ownership of Chinese onshore bonds remains at a low 1.7%.
Overseas fund managers have said their top concerns include the country’s tight control over repatriation of invested funds, unpredictable financial policies, and a regulatory labyrinth for foreign investors, according to a survey of over 100 large fund managers by Asia Securities Industry & Financial Markets Association (ASIFMA) released in September.
Ease of access, however, does not top their list.
“In fact, the system and arrangement in place are fine. The key issue (of the onshore bond market) is the market is not attractive enough,” the head of fixed income at a local brokerage said. “The outlook for China’s monetary and regulatory policies is highly uncertain. Even we locals find it hard to decipher, let alone foreign investors.”
How far has China gone?
China has opened up its bond market to foreign investors in a very measured pace. The government’s concerns over capital outflow and not-yet-ready trading infrastructure trump its desire to let foreign investors help drum up trading activity, analysts said.
The country first allowed overseas investors to trade government bonds, convertible bonds and corporate notes listed on onshore exchanges through the Qualified Foreign Institutional Investor (QFII) program, launched in 2002. Then in 2010, it opened up the interbank bond market, where more than 90% of notes are traded, to a small group of foreign investors — central banks, yuan clearing houses in Hong Kong and Macau, and international financial companies engaging in cross-border yuan settlement. As of February 2016, all overseas financial institutions are eligible to trade in the interbank bond market.
In the National People’s Congress conference in March, Premier Li Keqiang proposed a pilot program for Bond Connect. Then, in May, the People’s Bank of China and Hong Kong Monetary Authority formally announced the program. Details and timing of the trading links have not yet been announced.
Under Bond Connect, China will remove some hassles for these investors. They will no longer be required to set up a bond account in China, which could easily take months under the QFII program. Instead, they will be able to trade and settle through a Hong Kong-based custodian system without a Chinese onshore license.
The program, as people close to the People’s Bank of China told Caixin, will play an integral role to bring in more foreign investors to help revive the domestic bond market.
Convenience might lure more overseas investors to dip their toes in Chinese notes without a presence in the country. But some fund managers, both domestic and overseas, said improved access alone does not directly address the other weaknesses of the bond market, such as illiquidity.
Improved market access is not enough
“Despite China’s attempts to diversify the investor base of the onshore bond market, the core issues, such as ineffective pricing and insufficient liquidity, remain,” said a senior executive at a domestic financial institution.
In China, trading of fixed-income products is not active relative to its size, in part because most bonds are held to maturity on banks’ balance sheets.
ASIFMA said in March that to drum up liquidity, China needs to create a trading environment that caters to the diverse needs and risk appetite of a wide range of domestic and overseas investors. The association said it can be achieved through opening the market of repurchase agreements, or repos, and hedging to more participants. The International Monetary Fund (IMF) also said in December that swap markets are crucial to bond-market liquidity.
For now, only central banks, sovereign funds, offshore yuan clearing banks and international financial companies like the World Bank are allowed access to Chinese onshore repo market. Commercial banks, insurers and institutional fund managers are not allowed to trade repos, nor hedging derivatives such as interest-rate swaps and forward contracts.
“Chinese markets are too big to be ignored, but foreign investors such as pension funds put great emphasis on liquidity when it comes to investment decisions,” ASIFMA CEO Mark Austen said.
Another concern is that China has yet developed a “reliable risk-free yield curve” — a set of reliable money market reference rates for different maturities to guide decisions on borrowing and investing in debts commonly used in developed economies.
A reliable yield curve helps attract more foreign interest as foreign debt managers are accustomed to pricing their risks this way, the IMF said.
“China has too many yield curves. Interbank bonds, government bonds and exchange-listed bonds each has their own yield curve. There is no one single benchmark here, therefore pricing can easily be distorted,” said a source at China Central Depository and Clearing Corp., one of the country’s clearinghouses.
An underdeveloped domestic credit ratings system also contributed to a pricing culture that is usually incomprehensible to foreign investors.
“Just imagine what foreign investors would think when many domestic bond issuers are rated AAA, even higher than sovereign ratings in some other countries?” said another seasoned local bond investor.
Unresolved or unclarified legal issues under Bond Connect could also dampen foreign interest. Ge Yin, Shanghai Head of Financial Services at law firm Clifford Chance LLP, warned that investors without an onshore bond account might not be able to offloads the notes freely. Ge said the current rules in China are unclear if investors under Bond Connect can pledge bonds as collateral to finance other transactions.
For now, execution details — including the arrangement on fund repatriation and legal framework on bond ownership — are scant. But after all, what matters most to foreign investors is unlikely to be market access, but an environment that allows them to maximize their returns with calculated risks.
Contact reporter Dong Tongjian (firstname.lastname@example.org)
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