Emerging Markets Bonds
CBON: Question & AnswerSunny Bokhari, ETF Product AnalystSeptember 08, 2021
China bond yields have remained steady this year, maintaining an attractive pickup compared to U.S. Treasuries. The Chinese bond market also has distinct traits that set it apart from both developed and other emerging markets bond markets. In our view, a targeted exposure to China onshore bonds presents an attractive opportunity. This blog is intended to answer frequently asked questions about China bonds and VanEck’s China Bond ETF (CBON).
Q: Why are there so few investment options available to access China onshore bonds?
A: Historically China’s bond market was not easily accessible to U.S. investors due to restrictions put in place by the People’s Bank of China (PBOC). However, China has been gradually opening up its financial markets to foreign investors with the introduction of a series of programs, beginning in 2002 with the Qualified Foreign Institutional Investor (QFII) program, followed by the Renminbi Qualified Foreign Institutional Investor (RQFII) program in 2011. Both programs allowed foreign investors to trade A-shares and onshore China bonds, subject to numerous restrictions including investment quotas and limits on repatriation.
Investment limits and other operational hurdles have gradually been eased, and new programs have also been introduced that have made it easier for foreign institutions to access the onshore markets. One of these important developments for the fixed income market includes the establishment of the Bond Connect program in 2017 that allowed qualified foreign investors to access certain Chinese domestic bonds trading on the China Interbank Bond Market (CIBM) through Hong Kong. In July 2021, PBOC announced that China would connect its vast interbank and exchange bond markets in an effort to unify the segregated bond markets, allowing qualified investors to buy and sell bonds in each market via a “connect” infrastructure.1 Increasing access and unifying markets will likely increase market liquidity and help to solidify China’s important role in the global markets.
Given the historical complexities of accessing China onshore bonds and the fact that onshore bonds were not even represented in global bond benchmarks until recently, there are not many funds that offer pure China domestic bonds exposure. VanEck China Bond ETF (CBON), launched in 2014, was the first U.S. listed ETF to provide China onshore bond exposure.
Q: Why invest in China bonds?
A: With $17.4 trillion in debt outstanding, China is home to one of the world’s largest onshore bond markets with only 3% currently owned by foreign investors.2 The market is forecasted to grow to approximately $25 trillion by the end of 2025.3 In the current yield starved environment, China bonds may offer not only attractive yields, but also lower volatility versus developed market bonds.
China Bonds: Higher Yield vs Developed Markets
10 Yr Government Yield (%) as of 8/31/2021
Chinese bonds may also offer attractive diversification potential, with lower correlations compared to other developed or emerging market bonds and other asset classes.
Correlation of Monthly Returns Aug 2016 – Aug 2021
China Onshore Bonds Local Currency EM Sovereign Hard Currency EM Sovereign US Aggregate Global Aggregate China Onshore Equities US Equities EM Equities China Onshore Bonds 1.00 Local Currency EM Sovereign 0.50 1.00 Hard Currency EM Sovereign 0.24 0.81 1.00 US Aggregate 0.12 0.24 0.49 1.00 Global Aggregate 0.46 0.61 0.65 0.79 1.00 China Onshore Equities 0.51 0.48 0.43 0.05 0.33 1.00 US Equities 0.21 0.50 0.57 0.01 0.24 0.56 1.00 EM Equities 0.53 0.76 0.66 0.08 0.45 0.77 0.73 1.00
As represented by China Onshore Bonds: ChinaBond China High Quality Bond Index; Local Currency EM Sovereign: J.P. Morgan Government Bond Index-Emerging Markets Global Core Index; Hard Currency EM Sovereign: J.P. Morgan Emerging Markets Bond Global Diversified Index; US Aggregate: Bloomberg Barclays U.S. Aggregate Bond Index; Global Aggregate: Bloomberg Barclays Global Aggregate Bond Index; China Onshore Equity: CSI 300 TR; US Equities: S&P 500 TR; EM Equities: MSCI EM TR.
Moreover, the inclusion of Chinese bonds in major fixed income benchmarks is likely to support capital inflows into the China bond market and could be a positive catalyst to growth in foreign ownership. By October 2021, China will be included in three major global bond indices: Bloomberg Barclays Global Aggregate Bond Index, JP Morgan Government Bond Index – Emerging Markets (GBI-EM) and the FTSE Russell World Government Bond Index. Capital inflows projected to be around $300 billion may follow through from assets benchmarked or tracking these indices.4
Index Inclusion Weight (%) Bonds Included Bloomberg Barclays Global Aggregate Bond Index 7.8 Government bonds, Policy bank bonds JP Morgan GBI-EM Global Diversified Bond Index 10.0 Government bonds FTSE Russell World Government Bond Index 5.25* Government bonds
Data as of 8/31/2021. *Estimated weight for China as given by FTSE Russell
China’s economy has proved to be resilient through the pandemic, with The World Bank projecting FY21 gross domestic product (GDP) growth of 8.5%. The Chinese government has been focusing on reforms to make its economy more domestically driven by manufacturing investment and consumption. The one-party system also provides stability to the country’s economic policy direction and implementation. Lastly, the macro outlook for the country is favorable with strong economic growth, including a rapid and remarkable recovery following the onset of the COVID pandemic in early 2020.
Q: What are the risks of investing in Chinese onshore bonds?
A: Chinese bonds come with certain associated risks, despite their attractive investment characteristics. An area of concern is the build-up in debt in “shadow banking” or off-balance sheet vehicles caused by the investment boom after the financial crisis. In addition, bonds issued in Renminbi leave foreign investors susceptible to currency and policy risks. Lastly, foreign investors may also have concerns around transparency, government interventions, and potential capital controls instituted by Chinese regulators.
While investors should monitor these risks, we believe there are factors that also help to offset potential concerns. Chinese public ownership of its debt is hard to determine, but it is likely to be higher than the U.S., especially in the banking system.5 China’s share of external debt is low relative to Renminbi debt, and its current account surplus, while declining, remains positive. Its domestic savings are also very high, providing support to the country’s currency, along with the country’s strong economic growth. Concerns about leverage are less of an issue for sovereign bonds and policy banks as the country has an A+/A1 rating from S&P and Moody’s. The risks of downgrades and defaults in corporate bonds is higher than sovereign bonds, but investing in high quality corporate bonds may offset some of those risks by offering attractive yields without taking on unreasonable risks.
Similarly, certain factors also reduce risks associated with currency and interest rates. The China Renminbi is a managed float currency that has historically been less volatile to external shocks. On the monetary policy front, China was one of the first countries to tighten market liquidity amid a strong economic recovery, while other developed markets were aggressively cutting rates. The result is a high real rate of interest, and the country has room to decrease interest rates to support economic growth if needed.
China trades about $3 trillion in goods and services and the government has been focused on liberalizing its bond market as part of a wider effort to establish Renminbi as an international currency and diversify domestic funding from bank loans to fixed income issuance. It does not seem likely to be an economy that is abruptly going to retreat and place capital controls, in our opinion.
Q: How is China’s onshore bond market structured?
A: The bond market in China comprises primarily two distinct sub-markets: CIBM and the exchange bond market. CIBM accounts for 88% share of total outstanding bonds at the securities depositories in mainland China.6 Certain foreign investors can access bonds traded in the interbank market directly or through the Bond Connect program. The significantly smaller exchange bond market is generally dominated by smaller investors as well as foreign investors under the QFII and RQFII regulations. Bonds that trade on both CIBM and the exchange market include treasury bonds, local government bonds, policy bank bonds and enterprise bonds. CIBM also trades central bank bills and medium-term notes and commercial paper, whereas the exchange market also trades short-term notes and corporate bonds. Individual markets are different in their sizes, types of instruments traded and are governed by different regulators.
There are six types of bonds traded in the onshore market: i) government bonds, ii) policy bank bonds, iii) local government bonds, iv) corporate bonds, v) financials bonds and vi) enterprise bonds. Policy bank issuance is about the same size as government bond issuance. Policy bank bonds are securities issued by the three government backed policy banks: China Development Bank, Agricultural Development Bank of China and Export Import Bank of China. These three policy banks provide the primary channels of financing for state projects, economic and trade development goals set by the Chinese government.
Structure of the Onshore China Bond Market
Asset Class Issuer % of total onshore market* Secondary Market Government Bonds Ministry of Finance 16 CIBM & Exchange Policy Bank Bonds China Dev. Bank, Agricultural Dev. Bank of China,
Export-Import Bank of China
16 CIBM & Exchange Local Government Bonds Provincials & Municipalities 23 CIBM & Exchange Corporate Bonds Corporates 8 Exchange Only Financial Bonds Financials 6 CIBM & Exchange Enterprise Bonds Corporates 4 CIBM & Exchange
Source: FTSE Russell, May 2020. *Does not sum to 100, since asset-backed, commercial paper and certificate of deposits are not shown.
As the regulators gradually lifted currency controls, an offshore Renminbi bond market has developed in Hong Kong, which is distinct from the onshore market. Chinese-based financial institutions can issue Renminbi denominated bonds in Hong Kong. These bonds are sometimes called “dim sum” bonds. This market has declined in size and liquidity as foreign investor’s ability to access the onshore market more easily has increased.7
Q: How is Renminbi managed?
A: Renminbi has been managed under the managed floating exchange rate system since 2005. The PBOC uses the China Foreign Exchange Trade System (CFETS) RMB Index as a gauge to monitor the yuan’s movements against a basket of 24 currencies. PBOC allows the yuan to trade in a 2% range around a mid-point that it fixes against the U.S. dollar each day. That mid-point is based on the yuan’s movement in the previous session as well as moves in currencies of China’s main trading partners. China also intervenes in open market operations using state-owned banks and utilizes its foreign currency reserves to keep the currency insulated from market shocks.
Currently there are two exchange rates for Renminbi, the offshore rate CNH and the onshore rate CNY. The onshore market includes the mainland China market whereas the offshore market includes Hong Kong, Singapore, London and Luxemburg. Foreign investors have generally perceived the offshore rate as more indicative of the currency’s value, given it is more market driven than the onshore rate and historically there were instances of higher spreads between the CNY and CNH. However, the market reforms to liberalize the market by Chinese regulators has minimized the differences between the two rates.
The managed float has helped CNY to exhibit low volatility relative to free float currencies and stability during times of market stress. This has also been a primary driver of the low correlation of onshore bonds with other asset classes.
Q: What is the difference between Chinese rating agencies and Western rating agencies?
A: The Chinese local rating agencies use a different rating scale than international ratings agencies and rely on domestic default rate data. They are not directly comparable to ratings by agencies such as Standard & Poors, Moody’s Investor Service and Fitch Ratings. State-owned enterprises (SOEs), banks and government back entities dominate local bond issues, resulting in lower default rates. The low default rates have translated in most companies getting an AA or above local rating (based on the Chinese rating scale). S&P (2019) and Fitch (2020) have recently received approval to cover the local bond issues. Local AAA ratings are generally viewed by foreign investors to be equivalent to broad “investment grade” securities when compared to Western rating agencies, but not necessarily equivalent to a AAA rating. However, there have been some recent defaults by firms rated AAA-by local rating agencies.
Current regulatory reforms are underway to penalize local rating agencies for any jump to default, and shifts of three or more grades besides an M&A event will trigger reassessment of their existing model.8 Regulatory reforms along with international rating agencies participating in the local bond issues may help to build more confidence among foreign investors relying on local rating agencies.
Q: Are investors being adequately compensated for the risks assumed to invest in China bonds?
A: Renminbi is less volatile than other currencies, making risk-adjusted unhedged returns attractive, in our view. China bonds not only offer a yield premium over developed market bonds but a low correlation to other asset classes. These characteristics have made China local currency bonds useful portfolio diversification tools. The internationalization of Renminbi as a reserve currency used in trade may promote stronger foreign investor demand for China local currency bonds along with their growing inclusion in major benchmarks. We believe the positive macro environment may also keep this asset class attractive to foreign investors.
3 Goldman Sachs Global Investment Research
4 Goldman Sachs Asset Management
5 FTSE Russell: Chinese Bond Market – Evolution and Characteristics July 2020
6 UOB Group Report: China Bond Market – Broadening Its Investment Appeal published April 26, 2021.
8 Bloomberg Intelligence: Improving China’s Credit Rating Quality
ChinaBond China High Quality Bond Index comprises fixed-rate, Renminbi-denominated bonds issued in the People's Republic of China by Chinese credit, governmental and quasi-governmental (e.g., policy banks) issuers.
J.P. Morgan Government Bond Index-Emerging Markets Global Core Index tracks bonds issued by emerging markets governments and denominated in the local currency of the issuer.
J.P. Morgan Emerging Markets Bond Global Diversified Index tracks the traded market for U.S.-dollar-denominated Brady bonds, Eurobonds, traded loans, and local market debt instruments issued by sovereign and quasi-sovereign entities.
Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. This includes treasuries, government-related and corporate securities, mortgage-backed securities, asset-backed securities and collateralized mortgage-backed securities.
Bloomberg Barclays Global Aggregate Bond Index measures global investment grade debt from 24 local currency markets. It includes treasury, government-related, corporate, and securitized fixed-rate bonds from both developed and emerging markets issuers.
The CSI 300 Index is comprised of the 300 largest and most liquid stocks in the Chinese A-share market.
The S&P 500® Index consists of 500 widely held common stocks covering industrial, utility, financial and transportation sector; as an Index, it is unmanaged and is not a security in which investments can be made.
The MSCI Emerging Markets Index captures large and mid-cap representation across emerging markets equities.
J.P. Morgan GBI-EM Global Diversified Index tracks local currency denominated EM government debt. The index weighting methodology limits the weight of countries with larger debt stocks.
FTSE Russell World Government Bond Index tracks the global sovereign fixed income market, measuring the performance of fixed-rate, local currency, investment-grade sovereign bonds.
This is not an offer to buy or sell, or a recommendation to buy or sell any of the securities/financial instruments mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. Certain statements contained herein may constitute projections, forecasts and other forward looking statements, which do not reflect actual results, are valid as of the date of this communication and subject to change without notice. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. VanEck does not guarantee the accuracy of 3rd party data. The information herein represents the opinion of the author(s), but not necessarily those of VanEck.
An investment in the Fund may be subject to risks which include, among others, investing in RMB bonds, RQFII regime, investing via the Bond Connect and the CIBM Direct Access Program, Renminbi currency, Chinese banking industry, PRC tax, sovereign bond, financial, industrials, credit, interest rate, subordinated obligations, foreign securities, emerging market issuers, cash transactions, market, operational, sampling, index tracking, authorized participant concentration, no guarantee of active trading market, trading issues, passive management, fund shares trading, premium/discount risk and liquidity of fund shares, non-diversified and concentration risks, all of which may adversely affect the Fund. Investments in mainland China may be subject to local customs, duties and rights of ownership, which might change at any time should policy makers deem them in China's best interest. As the Fund invests in securities denominated in Chinese Renminbi, changes in currency exchange rates may negatively impact the Fund's return. Foreign and emerging markets investments are subject to risks, which include changes in economic and political conditions, foreign currency fluctuations, changes in foreign regulations, changes in currency exchange rates, unstable governments, and limited trading capacity which may make these investments volatile in price or difficult to trade.
Through the Renminbi Qualified Foreign Institutional Investor (RQFII) program or Qualified Foreign Institutional Investor (QFII) licenses, RMB Bonds are made available to certain foreign investors. The RQFII approves a specific aggregate dollar amount in which the RQFII or QFII can invest in RMB Bonds. The size of the Fund's direct investment in RMB Bonds will be limited by the size of the RQFII quota, and should this quota be depleted, there is no guarantee more will be granted.
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Authored bySunny Bokhari
ETF Product Analyst