The Daily Update - Bond Connect lift-off

Today is expected to be a relatively quiet day across markets with the US out celebrating the July 4th holiday. Elsewhere, yesterday marked the 20th anniversary of the handover of Hong Kong to China, and the launch of the China-Hong Kong ‘Bond Connect’ platform. Bloomberg expects this new platform to be ‘the world’s biggest-ever financial product offering’. It is designed to allow foreign investors access to the USD 9.4tn China-Hong Kong bond market without a quota, or other technical hurdles.

 In our view, Bond Connect is an extremely positive development making it easier for international investors to gain access to the Chinese bond market. From a market capitalisation standpoint, and given the importance of China in the world economy, most investors are severely underweight renminbi assets in general. Unlike the QFII and RQFII schemes, Bond Connect is not subject to a quota which will make it easier for investment managers to gain exposure. This will be particularly beneficial for the smaller firms who may have been previously reluctant to go through the more time consuming process of applying via QFII or RQFII. Although the greater benefit may initially accrue to smaller firms, the lack of quota at the firm level may in due course make Bond Connect the preferred route to access Chinese bonds, even for the larger firms.

As with most countries, China will benefit from allowing international investors access to the domestic bond market as increased trading volumes will tend to lower the cost of capital, other things being equal. At present, international investors hold less than 2% of the Chinese bond market, which is far too low given the importance of the Chinese economy and the scale of the bond market. At Stratton Street we do not follow bond indices, which are constructed in a way that gives the biggest weight to the most heavily indebted companies and countries in the world. Instead we look for the most undervalued bonds and currencies and this led us to launch the Renminbi strategy almost 10 years ago. Ten years later, a number of bond index providers are to either include, or are considering adding China to their bond indices, and it seems inevitable that investors will hold more renminbi assets in the future than they do today. As such, most investors would be wise to consider how best to access the Chinese bond market and Bond Connect seems to offer a convenient and cost effective way to gain exposure.

Until the renminbi is widely held outside of China, many investors will only consider holding renminbi assets if they expect gains in the currency. At present, international investors have relatively negative views towards the Chinese currency which reduces the perceived need to hold renminbi assets. At Stratton Street we consider this view to be misplaced as our research suggests that countries, like China, which run persistent current account surpluses will see their currencies appreciate over time. The return to a stronger renminbi will become more obvious once the Fed comes close to the end of the current tightening cycle and the US economy starts to slow. 

Bond Connect will clearly make it easier for investors to access the Chinese bond market which in turn makes it easier for investors to hold renminbi. As the renminbi becomes more widely accepted as a settlement currency, the internationalisation of the renminbi can only grow and with it demand for Chinese bonds will only increase over time. For these reasons, it seems a risky strategy for investors to be underweight renminbi and Bond Connect could well provide a solution for many.

Most investors underestimate the scale of China and the fact that its bond market is the third largest in the world. MSCI recently made the first steps to include China A-shares in their emerging market index and so the trend to greater inclusion of renminbi assets is already underway. In the bond market, China perhaps wields even greater importance. Estimates vary, but some calculations suggest that China could eventually represent 18% of the major world bond indices. Every benchmark oriented bond investor in the world will need to have a significant exposure in their global bond portfolios with a weighting of that size. And those that transition first are likely to have an advantage over those that will inevitably follow.