Bond Connect: new progress on liberalization

In the past two years, with the launch of “Shanghai-Hong Kong Stock Connect” and “Shenzhen-Hong Kong Stock Connect”, Hong Kong has become the hub to connect the mainland market and the global market.

With the launch of Bond Connect, the scheme attracts southbound capital from the mainland on one hand while it will enhance the profile of Hong Kong bond market overseas on the other hand. The scheme will be instrumental in activating the bond market transactions resulting in promoting the Hong Kong bond market expansion filling the gap for Hong Kong to be an international financial center.

The mainland bond market has reached RMB 67.6 trillion (around EUR 8.7 trillion) and has become the world’s 3rd largest bond market.1 If the mainland bond market will grow in line with the average annual growth rate of 23.8% in the past 5 years, the mainland bond market will be close to RMB 200 trillion (around EUR 25.8 trillion) in 5 years, a market sizeable enough to meet global investment needs.

However, the current participation of overseas investors on the mainland bond market is relatively low. Take the treasury bond as example, the percentage of treasury bonds holds by overseas institutions accounted for less than 4% of the total indicating considerable room for further uplift. After the launch of Bond Connect, overseas institutional investors can utilize the Hong Kong RMB offshore market for more flexible participation in the mainland bond market introducing new capital streams.

The mainland bond market has been undergoing a 7-month adjustment, quite substantial adjustment, since November last year. As we are aware that any financial market follows the secular bull and bear market trends, the environment of current mainland bond market possesses strong allocation value.

In the past few years, the mainland has completed the “marketization of interest rate” while commercial banks faced unprecedented competitive pressures. Through borrowing money from the central bank, industry players and financial management, the commercial banks have expanded their sizes and improved their rights to speak in order not to be marginalized. From the perspective of commercial banks, they had been forced to do so in order to survive. In fact, this competition process over-stretched the capital chain with high degree of capital utilization undermining the defense against external shock. As a result, the central bank and the China Banking Regulatory Commission issued a series of regulatory policies to prevent risks.

From the perspective of historical comparison, the current adjustment of the bond market is sufficient. At the end of 2013, the mainland bond market experienced a wave of collapses to uncommon adjustment extent as a result of regulatory tightening. With this round of bond market adjustment began in November last year, the extent of upward bond yield move is roughly the same as that of 2013. Therefore, there is not much room for further downward market move.

Looking at the economic fundamentals, since the US subprime mortgage crisis in 2007 and the further Chinese growth pivot decline, the economic stage moved from the “high growth period” to the “medium-to-high development period.” According to international experience, economic pivot determines interest rate pivot. The downward trend of the Chinese economic pivot should coincide with the downward trend of interest rate. After a long period of adjustment, China’s bond yields have returned to above historical average. In other words, there is deviation between the current Chinese interest rate and economic fundamentals indicating space for bond yields to continue its upward trend is limited.

Comparing with international markets, the European high yield bonds and emerging market bonds have been performing well since the beginning of this year. Even in the United States, under the rate hike cycle, the room for further upward bond yield movement is relatively limited. As a result, the sharp upward movement of the Chinese bond yields further widened the interest spread between China and the overseas market enhancing the attractiveness of the mainland bonds and benefitting its subsequent performance.

Overall, the mainland bond market has already possessed good allocation value. Under the objective of anti-risk policies, supervision will not be relaxed over the short-term while the bond market may not embrace an upward trend. For overseas investors, especially for those who face allocation need, we believe the launch of Bond Connect is a good timing to participate in the onshore bond market.

Michael Chow – Head of International Business, Managing Director – Fullgoal Asset Management