The recent inclusion of the Chinese onshore bond market within broader global bond indices has increased the level of investor attention to the market. Despite its size, the Chinese onshore bond market behaves somewhat differently to those of developed markets. This has implications for investors who assume that they can simply adopt a passive exposure to this market.
Rapid Expansion in the Chinese Bond Market
Though foreign participation remains quite limited, the Chinese onshore bond market has experienced rapid growth. In 2002, the central government first opened the market to offshore investors via the Qualified Foreign Institutional Investor (‘QFII’) program. Since then, the Chinese Onshore bond market has experienced staggering growth from approximately CNY5trn to just under CNY90trn by the end of 2018 (Figure 1).
This rapid expansion has resulted in the Chinese onshore bond market growing to become the second largest bond market in the world (Figure 2). Despite its size China’s onshore bond market still retains some of the characteristics of a developing market; i.e. exhibits material differences to the other large developed bond markets.
What is in the Benchmark?
At first glance, any differences would appear to be negligible given the types of bonds the index providers have chosen to include in the indices. Using one of the more commonly used global bond indices - the Bloomberg Barclays Global Index - as an example, the included exposures comprise Central Government Bonds and Policy Bank Bonds1. These more liquid bonds constitute those parts of the bond market which are explicitly guaranteed by the central government.
Split evenly, these two bond classes together comprise nearly 40% of outstanding issuance. Being the largest and most liquid parts of the Chinese onshore bond market, investors may feel that such an exposure is advantageous as it facilitates accessing the market via passive benchmark replication. Unfortunately, market nuances with respect to the behaviour of central government bonds can act to frustrate these expectations.
‘On-the-run’ versus ‘off-the-run’ and the impact on liquidity
In this case the nuance of particular interest involves whether the bonds are ‘on-the-run’ or ‘off-the-run’ as this impacts the liquidity of central government bonds. The distinction between the two types of issues is that ‘on-the-run’ bonds are those which are currently being issued by the government while ‘off-the-run’ are those where there is no active issuance being undertaken. This distinction exists in all bond markets as governments target particular ‘terms to maturity’ as part of the current borrowing programs. Obviously as time passes the preferred maturity date for new issuance will also change. Within bond markets for developed countries, while there may be differences in the level of liquidity between these types of bonds, for ‘all intents and purposes’ the difference is normally negligible. Where China differs, is that the impact on liquidity is quite material. For ‘on-the-run’ bonds, trading spreads are only a bp or two but this blows out substantially as they become’ off-the-run’ while liquidity also declines materially. Such a difference in trading spreads means that the only central government bonds which would be considered as liquid, in a developed market sense, are those which are the current ‘on-the-run’ bonds.
The driving force behind the marked difference in liquidity arises from the banking regulations applied in China. Banks in China are required to hold bonds on one of two books the ‘trading book’ or the ‘hold to maturity book’. The difference is that for a bond to remain on a bank’s ‘trading book’ it must be traded within 90 days. Given this requirement, the only bonds which banks will tend to hold within the ‘trading book’ are those in which new issuance by the central government is currently occurring. Once issuance has ceased and moves on to the next line of bonds, ‘on-the-run’ bonds become ‘off-the-run bonds’, the banks transfer their existing bonds to the ‘hold to maturity book’ which effectively ceases the trading in the bonds by the Chinese banks. The result is a material decline in liquidity once a bond moves from being ‘on-the-run’ to ‘off-the-run’ as bank participation, which together hold more than 60% of central government bond issuance, largely ceases. Though not all trading in central government bonds ceases, only that with banks acting as counterparties, the cost of trading increases materially and dealing volume becomes more problematic. For investors trading such ‘off-the-run’ bonds, this also means closer monitoring of markets is required to be able to take advantage of any ‘pockets’ of liquidity when they arise.
Implications for investors
Investors considering investing in onshore China bonds need to recognise that market dynamics, even within the most liquid part of the market, can differ from developed markets. Even when dealing with central government bonds which are included within the benchmark there can be marked differences in the level of liquidity, and hence associated trading cost, between different bonds. These differences in liquidity makes the passive replication of a benchmark more problematic. Ensuring the appropriate management of liquidity and transactions cost within a portfolio requires:
- proactive management of holdings to maximise the exposure to ‘on-the-run’ central government bonds; and
- on the ground resources monitoring market conditions to take advantage of pockets of liquidity within ‘off-the-run’ bonds when they become available.
By recognising the nuances associated with the central government bond market in China and taking the appropriate steps, investors will be in a better position to maximise the returns from their on-shore China bond exposures.
Off-the-run bonds used to refer to bonds approaching maturity (c. 90-180 days). As many bond managers could not hold such portfolios due to refinance risk, it was not unusual to observe a slight increase in yields at this time. Is that still the case, Clive ?
Yes. We still see a bit of a pricing disconnect once Aust govt bonds have only one coupon left; i.e. become priced as discount securities. The issue is that such securities have no 'natural' holders. Bond managers don't need to hold them and money mangers are not attracted to the lower yield versus NCDs.