China’s sliding yield lure delays mass inflows to bond market

China’s debt is becoming less and less appealing to foreign investors seeking a yield pick- up, helping curb inflows in recent weeks and spurring a debate over projections for as much as trillions of dollars to pour into the world’s third- largest bond market.

The yield premiums on 10-year Chinese government bonds compared with US Treasuries shrank to just 26 basis points on Thursday, the smallest in almost eight years.

It’s significantly less than the advantage enjoyed in July 2017 – 124 basis points – when China opened up a new channel for overseas investors to buy its debt securities via Hong Kong.

Some market players play down the importance of the spread for global investors looking at Chinese debt as a diversification play – especially the central banks and sovereign wealth funds with long- term perspectives. Others say that with China’s increasingly flexible exchange rate, capital flows should follow the same dynamics as other major currencies – and pay attention to yield.

The latest debt- holding figures sug- gest that the shrinking yield premium, perhaps along with the yuan’s depreciation this year, is taking a toll. Foreign investors were net sellers of Chinese bonds for the first time in 20 months in October, trimming at least 9.6bn yuan ($ 1.4bn) according to the China Central Depository & Clearing Co and Shanghai Clearing House.

Here’s a selection of comments from analysts and fund managers on the issue:

Becky Liu, head of China macro strategy at Standard Chartered Plc in Hong Kong: The narrowing yield gap and the near- term volatility may delay foreign investments, slowing down the pace in the near term. But it’s not going to be big enough to materially reverse the inflows.

Some 80% of inflows so far are from public sector investors such as central banks. Private institutional investors are also getting ready to invest in China’s onshore bonds. The structural allocation shift is still at an early stage.

Xie Yaxuan and fellow analysts at China Merchants Securities Co wrote in a note this week: A stronger dollar and rising long- term Treasury yields are becoming negative factors for overseas investors.

Inflows through the first half of 2019 will probably drop 50% from the pace seen earlier this year. Overseas funds aren’t a saviour for Chinese bonds. As the market becomes more open, flows will significantly increase the volatility of the yuan’s exchange rate.

Jean-Charles Sambor, deputy head of emerging-market fixed income at BNP Paribas Asset Management. We’ve recently increased our positions in China’s policy- bank notes on the shorterduration side. The securities still offer attractive carry.

Longer term, we think that US and China will have de- synchronised monetary policy, and Chinese government bonds are still under- owned by foreigners.

Hayden Briscoe, Asia Pacific head of fixed income at UBS Asset Management: A lot more central banks and sovereign wealth funds recycle their yuan proceeds from exports to China to buy Chinese government and policy-bank bonds.

It’s less about the yield gap between China and the US but more about I need to get into whatever the number I’m targeting in portfolio allocations.

Briscoe earlier this year projected $3tn of inflows by 2020 as China’s bonds join major global bond indexes.