With China making great strides to liberalize its financial markets, it’s no surprise that foreign investors are keen to join the party. While asset managers found a relatively easy path to acquiring Chinese equities using a solution that goes through Hong Kong, buying Chinese onshore bonds had proved a tougher challenge. No longer.
On March 21, the Central Bank of Ireland (CBI) gave a green light to Dublin-based UCITS managers, who manage $2.03 trillion AUM, as well as AIF managers, with some $700 billion AUM, to begin using Bond Connect, a mechanism that makes it possible for foreign investors to access the China Interbank Bond Market (CIBM) through the Hong Kong exchange rather than going via the more cumbersome administrative process on the mainland.
The CBI’s decision was particularly timely because on April 1 Bloomberg announced that Chinese local currency bonds will be included in the Bloomberg Barclays Global Aggregate Index. It’s another step forward for foreign participation in the Chinese bond market and begins a phased process which will run for 20 months. Some predict this will result in foreign inflows of $150 billion into the $13 trillion bond market. Bloomberg said that at the conclusion of the phase-in period, Chinese fixed income instruments would represent about 6 percent of the index, becoming the fourth largest component after US dollar, euro and Japanese yen denominated bonds. In addition, other benchmarks such as the FTSE Russell World Broad Investment-Grade Bond Index and J.P. Morgan’s JPM GBI-EM Diversified Index are also considering adding Chinese securities.
It is the scale of this new opportunity that is making many global asset managers consider the best means of accessing the market and many are excited by the Hong Kong China Bond Connect.
Hong Kong ‘s Mature Legal Framework
Bond Connect works in a similar way to the Shanghai and Shenzhen Stock Connect programs for equities that allow investors in each location to trade on each other’s exchanges. Hong Kong is an important conduit for foreign investors because it features a more familiar legal framework that is similar to the legal systems in Europe and the US.
A Mandatory Investment Decision
Why is this important? The inclusion of Chinese bonds in these global indexes makes them a mandatory purchase for a lot of UCITS and other fund managers that are either passive or track one of the major global bond indices. If you are a global bond manager, you now need to be able to trade these yuan-denominated bonds easily and Bond Connect seems like a sensible route to market. Through these indices revisions, Chinese fixed income gains the same kind of compulsory status in certain bond portfolios as bonds from the US, Europe, and Japan.
Since Luxembourg had already taken a similar decision on Bond Connect in stages last year, CBI’s move means the European regulated fund space now has a harmonized approach which should generate increased confidence and more scale and volume of Chinese bond purchases for both UCITS and AIFMD funds.
While Bond Connect started trading in July 2017, the rules had to be refined before regulators became convinced transactions would meet the EU’s own requirements for UCITS investments. For example, last August, the People’s Bank of China dropped the requirement for prefunding bond trades and adopted delivery versus payment settlement, removing an unacceptable settlement risk. It also agreed to allow block trades, allowing asset managers to allocate trades to multiple accounts.
Asset Safekeeping Rules
The Chinese market also had a significantly different approach to how assets should be held for and on behalf of investors. The CBI essentially had to become comfortable that trading through Bond Connect for Irish investors would be no riskier than trading bonds in New York, London, or Europe. That comfort has now been secured through dialogue with industry stakeholders.
Under the EU’s technical rules, a UCITS fund must hold an asset in its own name and it cannot be held by a nominee, as is normally done in China, where the nominee holds the legal title and does the recordkeeping for the underlying owner. What Bond Connect has done is create an elegant mechanism to bridge the gap between UCITS safekeeping requirements and Chinese mainland standards. Now, the bond investment can be held for the benefit of the investor in the legal name of the fund’s depositary for the underlying fund. If the depositary retains control of the bonds, the CBI is satisfied that UCITS and AIF rules are met and its guidelines will reflect these changes.
This is likely to be a major development for fund managers. With China’s ambitious infrastructure construction program, it’s likely that Chinese bond allocations will continue to grow in scale and significance for global asset managers, possibly even overtaking US Treasuries because of the scale and rate of China’s growth. Bond Connect is one useful market mechanism now making it far easier for foreign investors to take a stake in the Chinese expansion.
 ANZ Global Research, 2019.