By Noah Sin
HONG KONG (Reuters) - China's yuan-denominated onshore bonds will be begin to be included in the Bloomberg Barclays (LON:BARC) Global Aggregate Index from Monday, and two other competing indices are likely to soon follow suit.
The milestone inclusion is expected to draw billions of foreign dollars into China's $13 trillion bond market, the world's third largest.
Here's why investors across the world are watching this closely:
WHICH INDEX PROVIDERS ARE ADDING CHINESE BONDS AND WHEN?
After years of anticipation, benchmark global bond indexes are finally incorporating China, drawing many investors - some for the first time - to this vast market.
Bloomberg Barclays Global Aggregate Index on April 1 will begin adding Chinese government and policy bank bonds over 20 months. The inclusion will eventually take China's weight in the index to 6.03 percent, Bloomberg said in January.
Chinese government bonds are also on a "watchlist" of bonds to join FTSE Russell's World Government Bond Index (WGBI), with a review set to take place in September, the index provider has said.
China was put on a watchlist for the J.P. Morgan Emerging Markets Government Bond Index Global Diversified, the other major bond benchmark, in 2016. JP Morgan will survey investor feedback on inclusion at its annual meeting this summer, a bank spokeswoman said.
WHY NOW?
Analysts have long argued China's bond market, the world's third largest, is too big to ignore. But restrictions have prevented many investors from tapping Chinese bonds.
China has over the years made access easier for foreign investors, most recently by launching the Bond Connect scheme in 2017, which allows investors to buy and sell onshore bonds via Hong Kong.
In the past year, authorities added two key capabilities: delivery versus payment and block trades, common features in financial markets elsewhere. Beijing also clarified how it will tax foreign investor gains from Chinese bonds.
The introduction of all three features were prescribed by Bloomberg in March 2018 as pre-conditions for index inclusion.
HOW MUCH MONEY WILL IT BRING CHINA?
The Global Aggregate Index is tracked by an estimated $2.5 trillion of portfolio assets under management. A 6 percent weighting would therefore bring $150 billion to Chinese fixed income, according to HSBC and several other banks.
But Goldman Sachs (NYSE:GS) in February cut its inflows forecast to between $120 billion and $150 billion, noting 10 to 20 percent of investors may not be ready to track the index on day one due to operational difficulties and other concerns. Standard Chartered (LON:STAN) made a similar observation.
Deutsche Bank (DE:DBKGn) also put its inflows estimate at $120 billion in a report last month, but it reached that conclusion while assuming the Global Aggregate is followed by a smaller $2 trillion pool of passive assets.
A 5 percent inclusion in WGBI will spur an additional $125 billion of inflows, and a 10 percent inclusion in JP Morgan's benchmark could bring another $22 billion to China, said HSBC.
WHAT DO INVESTORS WORRY ABOUT?
Recently issued Chinese government bonds tend to be much less actively traded, or "liquid", once a new batch of issuance comes through. That could make it difficult for index-tracking investors to replicate the inclusion portfolio, said ASIFMA, a financial industry lobby.
The toolkit to manage interest rate risks is also limited. Hedging instruments such as bond futures and repos are open only to some foreign investors, said ASIFMA, which has also called for wider liberalization of the derivatives market.
With Chinese bonds representing a mere 6 percent in the Global Aggregate Index, most investors seem happy to overlook these shortfalls, though that may change as the country's weight in global indexes goes up.