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Second Largest Bond Market In The World: What Investors Need To Know About The Hong Kong China Bond Connect Program

Prior to Bond Connect, the ways foreign investors could invest in Chinese onshore bonds were limited in scope and had their own restrictions: QFII, RQFII, and the China Interbank Bond Market. Bond Connect, the fourth channel, aims to improve operational efficiency for foreign investors, especially with regard to account openings and trade transactions. Another goal of Bond Connect was to promote the potential inclusion of Chinese onshore bonds in major global indices. This was achieved in 2019 when Bloomberg added Chinese government bonds and Policy Banks bonds to the Bloomberg Barclays Bond Index (with a weighting of 6%), and JP Morgan added several highly liquid Chinese government bonds to various bond indices.

Bond Connect Overview: How Does Bond Connect Work?

As part of Bond Connect, investors submit settlement instructions to Hong Kong's Central Moneymarkets Unit (CMU), which acts as the nominee holder of these securities and clears them through onshore clearing houses.

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As a result, foreign investors do not have to open an onshore account, but instead receive a CMU account number for the settlement process. The CMU can issue certificates as evidence of bond ownership to investors that are recognized by the PBoC.

In order to buy and sell bonds, investors must submit an RFQ to selected participating onshore traders on offshore trading platforms (e.g. Bloomberg or Tradeweb). Then they have to obtain or execute the most favorable price quotation. These offshore trading platforms are connected to the onshore trading platform CFETS (China Foreign Exchange Trade System). Once a trade is completed, CFETS transmits the trade information to two onshore CSDs - Shanghai Clearing House (SHCH) and China Central Depository & Clearing Co. Ltd. (CCDC).

The funding currency can either be offshore renminbi (CNH) or a foreign currency. Investors can choose to convert foreign currencies or CNH to onshore renminbi (CNY), subject to the current exchange rates of offshore banks. It should also be noted that the repatriation currency should always be the same as the funding currency.

Bond Connect acceptance

July 3, 2020 marked the third anniversary of the introduction of Bond Connect. During this time, 2068 institutional investors (including JK Capital) from 33 countries have opened accounts with Bond Connect, including 72 of the world's top 100 wealth managers. Upon closer analysis, the average daily trading volume of Bond Connect was around 2-3 billion RMB in 2017 and rose to 19.9 billion RMB (or $ 2.8 billion per day) in the first half of 2020. The graph below shows a solid upward trend in monthly Bond Connect sales.

Source: CEIC

Source: Bond Connect

The importance of the Chinese onshore bond market

The Chinese onshore bond market was over 97 trillion RMB ($ 14 trillion) in outstanding bonds in 2020 and is the second largest bond market in the world after the US, but ahead of Japan, the UK and other European countries. This corresponds to an annual growth rate of over 20% per year over the last 5 years.

Source: SIFMA, Bloomberg

Despite its size, foreign investors only held about 3.5% of the broader Chinese onshore bond market at the end of June 2020, according to the CEIC. This is largely due to regulatory restrictions as the Chinese government has strict capital controls. With the introduction of Bond Connect, however, the PBoC wants to improve access for global investors to the financial markets. The number will continue to grow as the major international bond index providers continue to include Chinese onshore bonds in their respective indexes.

Source: CEIC

What did foreign investors buy?

Foreign investor capital flows have been mainly concentrated in the Policy Financial Banks (PFBs), the Treasury (i.e., Chinese government bonds) and the short-term Negotiable Certificate of Deposits (NCDs). Capital inflows were fueled by tax exemptions on government bonds and higher returns on short-term NCDs.

Source: Bond Connect

Capital inflows into “Other” include corporate bonds. Interest in these types of bonds was relatively subdued due to their poor liquidity. In addition, the Chinese onshore market for rating agencies is still in its infancy, as the US rating agencies Moody's, Fitch and S&P were only allowed to open a 100% independent onshore business in 2017. One hurdle for the Chinese onshore rating market is that 81% of Chinese onshore bonds have a “national scale rating” between AA and AAA. This makes comparisons with international bond ratings quite difficult given the different weighting of the various factors by the agencies. For example, domestic agencies place greater emphasis on asset size as a positive factor, while global agencies place greater emphasis on leverage as a negative factor. Profitability and state ownership also have a more positive weight for international agencies.

What's next with Bond Connect?

Bond Connect has continued to evolve since it was launched three years ago. First, tax incentives were introduced for offshore investors who invest in onshore bond markets. A limited exemption from corporation tax and VAT for three years is granted for interest income from bond investments. Second, Bond Connect is constantly expanding the number of participating onshore traders while significantly reducing the fees associated with using the Bond Connect platform. Finally, Bond Connect also introduced DvP (delivery versus payment) processing to increase settlement efficiency and reduce settlement risk.

Another option that should not be ignored is the "southbound trading" business. In May 2020, four Chinese authorities, including the PBoC, published a white paper entitled “The Opinions on Financial Support for the Construction of the Greater Bay Area Guangdong-Hong Kong-Macau”, in which for the first time the optimization and improvement of financial market connections in the Greater Bay Area along the Pearl River Delta was proposed. In the document, the study on the expansion of "southbound trading" was discussed in detail. We expect developments to move forward soon and mainland investors to gain access to the international bond markets.

Eric Tso, Fixed Income Analyst, JK Capital Management Ltd., a La Française company

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