WGBI – the latest major index inclusion for China

One of the most important developments in global finance is the ongoing internationalisation of China’s bond market. Over the last few years, Chinese onshore debt has undergone a dramatic transformation – from an asset class that was largely inaccessible to foreign investors, into a market that is a mainstream asset for the international investment community.

Index inclusion has played a key role in this evolution, as Chinese debt is added to the major benchmarks that active investors use to measure their performance and passive investors use to build their portfolios. The next milestone on the indexation journey is China’s upcoming inclusion in the FTSE World Government Bond Index (WGBI), which is expected to take place in November this year. It is a major event that HSBC estimates will lead to passive inflows into Chinese government bonds (CGBs) worth USD140 billion to USD150 billion over a 36-month inclusion process¹.

In addition to index inclusion, there are a wide range of factors encouraging foreign investors to allocate capital to China, said André de Silva, Global Head of Emerging Markets Rate Research, HSBC. “There is an inextricable link between diversification, yield, carry and structural demand, as the world’s third largest market opens up,” he said, speaking at HSBC’s China Conference. This helps explain the strong inflow into CGBs: USD26 billion in the first quarter of 2021, which follows USD84 billion last year, he said.

From a yield perspective, he said that China offers a superior rate compared to the other WGBI constituents, which for ten-year bonds is currently around 140 basis points above US Treasuries and 300 basis points higher than Japanese government bonds. And when compared to the other emerging markets in the index – such as Poland and Malaysia – China offers a better combination of yield and ratings, said Mr. de Silva.

Measuring the impact

China’s addition to WGBI will have a significant impact on the index. Chinese government bonds will have a weighting around 5.44 per cent, according to a FTSE Russell representative speaking at the China Conference. This would make it the sixth largest country in the index, though this figure could change by the time inclusion actually takes place.

It will be the single largest inclusion event in the index’s history, since many of the large developed markets have been part of the WGBI since its launch, and the addition of some emerging markets over the last two decades have had less than 1 per cent weight, said FTSE Russell. The index’s overall yield will rise after inclusion of Chinese debt, while duration will be slightly reduced.

Looking beyond WGBI itself, the inclusion event will have ramifications for the entire Chinese bond market. The anticipated inflows will increase the foreign ownership from 10 per cent seen in March to 14 per cent by 2024, said Mr. de Silva.

Although this would be a substantial change, foreign holdings of Chinese onshore debt would still be lower than other markets, he said, suggesting further room for growth. He compared to it to South Korea, where 18 per cent of government debt is held by foreign investors, while for US Treasuries the rate is 34 per cent.

Continued foreign purchases of Chinese debt will extend a trend that has already made overseas investors the second largest buyers of CGBs, according to FTSE Russell. The market will remain dominated by local commercial banks that tend to hold bonds until maturity. However, the introduction of more active foreign investors will provide liquidity to the market – especially passive funds that will regularly buy and sell bonds to meet their rebalancing needs.

Active versus passive investors

FTSE Russell is only the latest in a series of major indices to include Chinese debt. In 2019, the Bloomberg Barclays Global Aggregate Index (BBGA) started its inclusion process, and last year the smaller J.P. Morgan Government Bond Index - Emerging Markets (GBI-EM) made a similar move. The upcoming WGBI inclusion will likely play out differently to earlier index events, said Mr. de Silva.

He highlighted the different kinds of investors that use the indices. WGBI is typically followed by passive investors, while BBGA is used more by active funds. So while BBGA investors had more freedom to decide on the extent their portfolio would track the change, with some investing ahead of inclusion, most WGBI investors will not frontload in advance.

Another consequence of the passive investor base that relies on WGBI is that it will bring stable money, which should ignore short-term volatility. This stands in contrast to active money managers who can reallocate funds from one country to another as they change their short-term views.

Finally, Mr. de Silva pointed out that the WGBI inclusion will take much longer than it took for BBGA or GBI-EM, due to a longer rebalancing schedule – 36 months, instead of 10 to 20 months for earlier indices. “The scale on a month-by-month basis will be much smaller than with other indices, but it will be more systematic.”