Chinese Bond Market Overview
FRAN RODILOSSO: China's domestic bond market is actually the third largest domestic bond market in the world. At more than 11 trillion U.S. dollar equivalent, Chinese bonds are larger than all other countries other than the U.S. and Japan. Interestingly, China's not included in many indexes yet, nor is it in many foreign investors' portfolios, but there's a very deep and liquid market for onshore bonds in China. Of that 11 plus trillion dollar equivalent of local currency bonds onshore in China, roughly four and a half trillion, are made up in equal parts of government and quasi-sovereign bonds. Quasi-sovereign bonds are bonds issued by three of China's development banks.
The other roughly 7 trillion in debt is made up of non-government financials, nonfinancial corporates, local government financing vehicles, local government debt issued straight by local governments, asset backed securities, it's a very diversified market.
Underrepresentation in Major Indices
RODILOSSO: For global bond portfolios or international portfolios for U.S. investors, many of those are built around referencing an index. And indexes have only in 2019, begun adding Chinese bonds to their investible universes. The main reason for that lack of index inclusion, lack of a presence in global portfolios, was access.
Actually for a number of years in, international investors have been able to access Chinese bonds, onshore bonds, but on a limited basis, through a quota system that required regulatory approval for the investor, that had quota limitation on the amount that could come in, but also holding periods and restrictions on how money could leave. Only in 2016, did the Chinese government start opening the domestic bond market for direct access outside of the quota system for international investors. That was initially largely institutional sovereign wealth funds, very large banks.
In 2017 China introduced the bond connect system, making it easier for financial firms globally to come in through Hong Kong. Much like the stock connect system functions, it gives foreign investors a little more flexibility with how they trade the foreign exchange with multiple counterparties.
So in short, the bonds are slowly entering indexes in 2019 and 2020. As that happens though, they'll remain underrepresented. Chinese bonds will probably cap out at around 6% of popular global aggregate indexes, and somewhere between seven and 10% of sovereign emerging market bond debt indexes, local currency ones.
Constructing a Portfolio with Chinese Onshore Bonds
RODILOSSO: Investors who approach onshore bonds, Chinese onshore bonds, from a portfolio construction perspective, should consider the fact, again, that this is a very deep, very large market. They should consider that it's going to remain for some time underrepresented relative to its size in any indexes they might track.
However, they should also consider that as the third largest bond market among the top dozen or so bond markets in the world, China has some of the higher yields. Most of the large bond markets in the world, outside the U.S., are extremely lower negative yielding countries. China's currency is likely to become increasingly tradable, perhaps a reserve currency over time. So while investors should have increasing ability to take advantage of investment and trading opportunities, and have hopefully, a liquid market to go in and out of, they should keep in mind that it'll probably be represented in indexes. And they might want to consider standalone allocations within their global bond portfolio. For a U.S. investor in international bond allocation, they might want to look at doing standalone allocations to China, not just through a broad indexes, where it will be underrepresented.