Invesco Global Insights

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1 Invesco Global Insights July 2016 The Opening of China s Bond Markets: Opportunities for Global Investors (Executive Summary) 1 Introduction China has the second largest economy and the third largest bond market in the world.² The offshore renminbi (RMB) bond market alone has more than quadrupled in size since 2010.³ It is therefore not surprising that events in China are among the most important factors affecting global risk assets. Due to various structural restrictions, however, foreign investment in Chinese fixed income markets has historically been quite limited, even when compared with much smaller emerging market countries. Steps recently announced by the People s Bank of China (PBOC) to broaden and simplify foreign access to the onshore Chinese bond market appear likely to change this. These steps are part of a broad, concerted effort by Chinese regulators and policymakers to open China s capital accounts and encourage internationalization of the RMB. 4 Given the significant implications of events in China for the global economy, it is critical for investors, including asset managers, to understand and react to the significant changes underway with respect to Chinese fixed income markets. Contributors Ken Hu Chief Investment Officer, Fixed Income, Asia Pacific Chris Lau Senior Portfolio Manager, Fixed Income, Asia Pacific Yi Hu Senior Credit Analyst, Asia Pacific Yifei Ding Fixed Income Analyst, Fixed Income, Asia Pacific Figure 1: China s domestic bond market is the third largest in the world USD billion 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 Government Corporate Financial 0 United States Japan China United Kingdom France Germany Italy Netherlands As of September 30, Source: BIS, March 6, 2016; Invesco. 1 For the complete version of this Invesco Global Insights white paper, which includes a comprehensive overview of offshore and onshore Chinese bond markets, please visit your regional Invesco website or contact your Invesco client service representative. 2 As of September 30, Source: Bank for International Settlements (BIS), March 6, See Figure 1. 3 Source: HSBC, as of December 31, Significant efforts by the Chinese government to internationalize the RMB began in 2010 with the creation of the offshore RMB (known as the CNH) and related offshore (or dim sum ) bond markets. Another notable step was taken in April 2014, when the government approved the Shanghai-Hong Kong Stock Connect program to facilitate wider foreign investment in onshore Chinese equities. Important information: The document is intended only for Professional Clients in Continental Europe, Dubai, Ireland, the Isle of Man, Jersey and Guernsey, and the UK; for Qualified Investors in Switzerland; for Institutional Investors in Australia and the US; for Professional Investors only in Hong Kong; for Qualified Institutional Investors in Japan; for Institutional/Accredited Investors in Singapore; for certain specific Qualified Institutions/Sophisticated Investors only in Taiwan; for Persons who are not members of the public (as defined in the Securities Act) in New Zealand. The document is intended only for accredited investors as defined under National Instrument in Canada. It is not intended for and should not be distributed to, or relied upon, by the public or retail investors. Canada Spain Australia The Opening of China s Bond Markets: Opportunities for Global Investors 1

2 Opening of Chinese Onshore Bond Markets China took another step toward the liberalization of its capital accounts and financial markets earlier this year when the PBOC announced a series of measures intended to facilitate and expand foreign investor access to onshore Chinese bond markets. Under the new rules, foreign commercial banks, insurance companies, securities companies, fund management companies, pension funds, charity funds, donation funds and other mid-to-long-term investors are now permitted to invest in the China interbank bond market (CIBM). Previously, foreign CIBM investment was restricted to foreign central banks, sovereign wealth funds, supranational organizations, RMB clearing banks, RMB settlement banks, select insurance companies, qualified foreign institutional investors (QFIIs) and renminbi qualified foreign institutional investors (RQFIIs). Investors Perspective: The Case for Chinese Onshore Bonds We believe that exposure to Chinese bonds, which currently offer relatively attractive yields and historically have shown a very low correlation to other regions fixed income assets, can add an important diversifying element to global bond portfolios. Low correlations with other assets From a portfolio management perspective, we believe that Chinese onshore bonds can potentially offer an attractive means for investors to diversify their assets and help reduce portfolio volatility. As demonstrated in Figure 2, Chinese onshore bonds have historically offered extremely low correlations with other bonds across the globe. The correlation with bonds in the US, Europe and emerging markets ranged between This reflects the significant potential diversification benefits offered by Chinese onshore bonds in contrast to global assets, which have tended to move in tandem when general risk sentiments change. Figure 2: Weekly correlations - between Onshore RMB bond index and selective global bond indices US Treasury US HY EUR IG EM Local CCY Govt Bonds Source Bloomberg L.P., Invesco 31 December, 2010 to 31 December, 2015 Asset Class (Represented Index) Onshore RMB (ChinaBond Composite Total Return Index), US Treasury (IBoxx USD Treasuries 10Y+ Total Return Index), US HY (Bloomberg USD High Yield Corporate Bond Index), EUR IG (Bloomberg EUR IG Corporate Bond Index), EM Local CCY Govt Bonds (JPMorgan GBIEM Global Index). 2 The Opening of China s Bond Markets: Opportunities for Global Investors

3 Potential for index inclusion and increased foreign ownership China s bond market has yet to be included in major local currency bond indices, partly due to the lengthy approval process, quota and repatriation constraints previously applicable to foreign investors. The PBOC s recent announcement has brought China s onshore bond market closer to being considered for inclusion in these indices. While the certainty, extent and timing of any such move remains unclear, if it does happen, investment portfolios tracking the relevant indices would need to increase their purchases of onshore Chinese bonds accordingly. We estimate that related inflows could ultimately reach USD billion from fund managers alone based on the potential weight of China onshore bonds in the indices and estimated size of assets tracking these indices. Moreover, foreigners currently hold less than 3% of Chinese onshore bonds, a level significantly lower than in most emerging market countries. 5 An increase of foreign ownership of China onshore bonds to 10% would represent an additional USD400 billion in foreign inflows to the onshore bond market. Higher yields than major developed market and many emerging market government bonds Although Chinese onshore bond yields tightened by basis points over the course of 2015, Chinese government bond yields to maturity still offered a 100-basis point spread over Asian countries with significantly higher foreign exchange volatility such as South Korea and Singapore as of the end of the year. 6 Compared to developed market countries, Chinese government bond yields currently appear more attractive in our view. The onshore Chinese government bond yield is trading at a bps premium over US and UK government bonds and at around 300bps over Japan and Germany s, which are trending deeper towards negative territory (Figure 3). Compared to the onshore market, offshore Chinese government bonds are even higher yielding, trading at a 60-70bps premium over the onshore equivalents. Although Chinese government bonds introduce currency risk when compared with developed market bonds, as discussed below we anticipate that this risk should generally remain relatively limited, given that RMB volatility has been significantly lower than major developed market and emerging market currencies. 7 Figure 3: Comparison of various government bond yields to maturity % China offshore China onshore South Korea Singapore US UK Germany Japan yr 3yr 5yr 7yr 10yr As of May 31, Source: Bloomberg L.P., Invesco. 5 As of March, Source: HSBC, Invesco. 6 As of December 31, Source: Bloomberg L.P. 7 Based on 12-month historical volatility measured as of May 31, Source: Bloomberg L.P., Invesco. The Opening of China s Bond Markets: Opportunities for Global Investors 3

4 Low foreign exchange and bond volatility Currency outlook and stability are crucial for local currency bond investors. The RMB has enjoyed the lowest volatility among global currencies, 8 which generally implies lower foreign exchange risk for bond investors. While volatility may increase if and to the extent that China moves toward a more freely floating currency, either as part of wider economic and financial system reforms or otherwise, we anticipate that policymakers will continue to place a high value on controlling RMB volatility. In this context it is worth noting that China benefits from significant currency reserves of USD3.2 trillion that could be used to support the RMB if necessary. 9 In addition, RMB bonds have experienced lower volatility over the past five years than bonds in Europe, the US and the emerging markets. Annualized historical volatility for Chinese onshore bonds was 1.4%, compared to 2.5% for European investment grade, 4.4% for US investment grade and 5.4% for global bonds. 10 While volatility levels are likely to increase as China further liberalizes its financial market, the onshore RMB bond market is still expected to exhibit lower volatility as the PBOC is able to exert greater influence over the market and China is less vulnerable to external shocks. Deep liquidity compared to global peers Contrary to widely held misconceptions concerning the liquidity of China s onshore bond market, turnover ratios for Chinese government and corporate bond trading are actually higher than those of some major developed market and emerging market countries. Although the absolute level of the government bond trading volume in China is still lower than that of the US, the eurozone and Japan, the level of corporate bond trading volume is approaching that of the US. 11 If we include policy bank bonds, which are considered sovereign credit risks and traded as rates products onshore, China s trading volume has outpaced the eurozone. The turnover ratio, which in our view provides a better gauge of trading liquidity, shows that Chinese government bond liquidity is greater than that of the eurozone and that Chinese corporate bond liquidity is considerably higher than that of global peers. 12 Yield comparison among the three markets Although all three Chinese bond markets provide exposure to the RMB and, to some degree, share a common issuer base, yields offered by the three markets can vary significantly because they are driven by different market trading mechanisms. The onshore market is driven primarily by the PBOC s monetary policy whereas the offshore market is also impacted by US rates and foreign exchange moves. A top down analysis shows that the RMB-hedged USD-denominated bond market has recently offered the highest yield to maturity among the three Chinese markets. 13 A bottom up approach, analyzing individual issuers on a case-by-case basis, shows that some issuers dim sum bonds currently offer the highest yield to maturity among the three markets. However, in most cases the same issuers USD bonds, if hedged back into RMB, would have enjoyed the highest yield. 14 Conclusion Fifteen years ago, investors seeking Chinese fixed income exposure had relatively limited options. Since that time, however, the continuing internationalization of the RMB coupled with the rapid growth of offshore Chinese bond markets have resulted in a substantially expanded investment universe for Chinese bonds. We expect that the PBOC s recent move to expand and facilitate foreign investor access to the onshore Chinese bond market will spur further investment and move Chinese bonds closer to being included in global indices, which we anticipate would lead to additional inflows. We believe that Chinese onshore bonds currently offer investors the potential to obtain attractive relative yields, greater diversification, low volatility and deep trading liquidity. And while uncertainties and risks certainly remain, the importance of the Chinese fixed income market the third largest in the world makes it crucial for global investors to understand and evaluate fully their options for gaining exposure to it. 8 Based on 12-month historical volatility measured as of May 31, Source: Bloomberg L.P., Invesco. 9 As of April 30, Source: People s Bank of China. 10 Source: Bloomberg L.P., Invesco, for the period from 31 December, 2010 to 31 December, Relevant indices: Bloomberg ChinaBond Composite Total Return Index, Bloomberg EUR IG Corporate Bond Index, Bloomberg USD Investment Grade Corporate Bond Index and JPM GBI Global Unhedged Index (USD), respectively. 11 As of December 31, Source: Wind, SIFMA, ECB, Trax, IIROC, Statistics Canada, Asian Development Bank, Invesco. 12 As of December 31, Source: Wind, SIFMA, ECB, Trax, IIROC, Statistics Canada, Asian Development Bank, Invesco. 13 As of April 30, Source: Bloomberg L.P., Invesco, CFETS, HSBC, Bank of America Merrill Lynch. 14 As of December 31, Source: Bloomberg L.P., Wind, Invesco. 4 The Opening of China s Bond Markets: Opportunities for Global Investors

About the contributors Ken Hu joined Invesco in April 2014 as Chief Investment Officer, Fixed Income, Asia Pacific.

Asia Pacific and overseeing fixed income investment products and processes.

He joins Invesco from Bank of China Hong Kong (BOCHK) Asset Management, where he has served as chief investment officer for fixed income since January 2011 and won the Best Offshore RMB Manager award

Prior to that Ken was chief investment officer for Bank of China Group Life Assurance, where he started investing in onshore RMB bond markets, and director of fixed income for HSBC Private Bank.

5 About the contributors Ken Hu joined Invesco in April 2014 as Chief Investment Officer, Fixed Income, Asia Pacific. He acts as fixed income senior investment professional and our primary liaison in Asia Pacific, and leads overall fixed income efforts in the region including growing our fixed income presence in Asia Pacific and overseeing fixed income investment products and processes. Ken has over 18 years of experience as an investment management professional, with much of his career dedicated to fixed income leadership positions. He joins Invesco from Bank of China Hong Kong (BOCHK) Asset Management, where he has served as chief investment officer for fixed income since January 2011 and won the Best Offshore RMB Manager award from Asia Asset Management in 2012 and Prior to that Ken was chief investment officer for Bank of China Group Life Assurance, where he started investing in onshore RMB bond markets, and director of fixed income for HSBC Private Bank. He also led the investment management activities for First State Investments and Income Partners Asset Management. Ken holds a Bachelor s Degree in Business Administration from the University of Wisconsin-Madison, USA and a Master s Degree in Finance from the Hong Kong University of Science and Technology. In 2005, he was invited by the Hong Kong University of Science and Technology as a Visiting Scholar to teach investment courses for its Bachelor s Degree programme. Ken is both a Chartered Financial Analyst and Certified Public Accountant. Chris Lau joined the Invesco Fixed Income as Senior Portfolio Manager in November He has been the lead manager of Invesco s Hong Kong liquidity portfolios since Chris also has regional responsibilities for the oversight of Invesco money market funds and help to grow liquidity products in the Asia Pacific region. Since July 2015, Chris became the co-manager for Asian fixed income portfolios covering both USD & local currency portfolios. Before joining Invesco, Chris worked as the portfolio manager at Bosera Asset Management International, managing onshore and offshore RMB and Asian HY bond funds from April Prior to that, Chris was the Head of fixed income at BOCI-Prudential Asset Management in HK, where he was managing global and Asian fixed income portfolios as well as money market funds. Chris earned a bachelor of Commerce degree from Monash University, Melbourne. Yi Hu joined Invesco in November 2014 as senior credit analyst. Prior to joining Invesco, she worked in HSBC for 7 years. Yi started with HSBC in London before moving to Hong Kong and working in the Asia credit team in Since then, she has been covering Asian banks with a special focus on the Chinese banking sector. Yi holds a MSc in Philosophy and Public Policy from the London School of Economics and Political Science and a BA in Economics from University of International Business and Economics in Beijing. Yi is also a CFA charter holder. Yifei Ding joined Invesco as Fixed Income Analyst in July He is responsible for macro and quantitative research in respect of Asian countries and assisting in the portfolio management of Invesco s Asian fixed income portfolios. Prior to joining Invesco, Yifei was Fixed Income Portfolio Manager/Analyst at Bank of China Hong Kong (BOCHK) Asset Management for three years whilst, before that, he worked at PricewaterhouseCoopers. Yifei obtained his PhD in Economics from the University of Oklahoma in the United States and a Bachelor of Science degree in Computational Mathematics from the Southeast University in China. 5 The Opening of China s Bond Markets: Opportunities for Global Investors

6 Important information The document is intended only for Professional Clients in Continental Europe, Dubai, Ireland, the Isle of Man, Jersey and Guernsey, and the UK; for Qualified Investors in Switzerland; for Institutional Investors in Australia and the US; for Professional Investors only in Hong Kong; for Qualified Institutional Investors in Japan; for Institutional/Accredited Investors in Singapore; for certain specific Qualified Institutions/Sophisticated Investors only in Taiwan; for Persons who are not members of the public (as defined in the Securities Act) in New Zealand. The document is intended only for accredited investors as defined under National Instrument in Canada. The document is for one to-one institutional investors only in Chile, Panama or Peru. It is not intended for and should not be distributed to, or relied upon, by the public or retail investors. This overview contains general information only and does not take into account individual objectives, taxation position or financial needs. Nor does this constitute a recommendation of the suitability of any investment strategy for a particular investor. It is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any trading strategy to any person in any jurisdiction in which such an offer or solicitation is not authorized or to any person to whom it would be unlawful to market such an offer or solicitation. It does not form part of any prospectus. While great care has been taken to ensure that the information contained herein is accurate, no responsibility can be accepted for any errors, mistakes or omissions or for any action taken in reliance thereon. The opinions expressed are those of Ken Hu, Chris Lau, Yi Hu and Yifei Ding may differ from the opinions of other Invesco investment professionals. Opinions are based upon current market conditions, and are subject to change without notice. Past performance is no guarantee of future results. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Asset management services are provided by Invesco in accordance with appropriate local legislation and regulations. This material may contain statements that are not purely historical in nature but are forward-looking statements. These include, among other things, projections, forecasts, estimates of income, yield or return or future performance targets. These forward-looking statements are based upon certain assumptions, some of which are described herein. Actual events are difficult to predict and may substantially differ from those assumed. All forward-looking statements included herein are based on information available on the date hereof and Invesco assumes no duty to update any forward-looking statement. There can be no assurance that estimated returns or projections can be realized, that forward-looking statements will materialize or that actual returns or results will not be materially lower than those presented. Note that strategies mentioned may not be available to all investors or in all jurisdictions. Please contact your local Invesco representative for more information. All information is sourced from Invesco, unless otherwise stated. All data as of May 13, 2016 unless otherwise stated. All data is USD, unless otherwise stated. invesco.com II-GICHBNDEXEC-INSI-1-E GL244 The Opening of China s Bond Markets: Opportunities for Global Investors

Invesco Global Insights

Invesco Global Insights July 2016 The Opening of China s Bond Markets: Opportunities for Global Investors Executive Summary China has the second largest economy and the third largest bond market in the