FTSE Russell’s Chinese government bond move heralds fresh opportunities for hedge fund investors

People's Bank of China, Beijing

FTSE Russell’s decision to include Chinese sovereign bonds in its flagship government bond index could offer hedge fund investors fresh alpha-generating and AUM-raising opportunities amid a wave of overseas capital inflows into the market.

FTSE Russell said last month it intends to include Chinese sovereign bonds into its flagship World Government Bond Index from next year.

The inclusion – which follows similar moves by Bloomberg Barclays and JP Morgan Chase, the other two main index compilers – tees up a range of investment opportunities for several hedge fund strategy types, industry observers said.

Man Group, the London-listed global hedge fund giant, believes the move will “almost certainly” accelerate foreign inflows.

The decision comes as Chinese bonds have been “on a tear in 2020”, Man said in recent a market commentary, while media reports elsewhere pointed to estimated investor inflows of some USD90-100 billion from September 2021 as a result of the decision.

Jim Neumann, partner and chief investment officer at Sussex Partners, said there had been a lack of ownership of Chinese government bonds among international investors, relative to the size of the bond market, up until now.

Man estimates that the value of the stock of foreign-owned Chinese government and agency bonds is less than 1 per cent of the market cap of the Bloomberg Barclays Global Aggregate for treasuries and agencies. It is also just 8 per cent measured as a share of the total stock of Chinese bonds. In contrast, for other emerging market countries, the number is often more than 20 per cent, Man said.

Currently, 10-year Chinese government bonds are yielding between 3 and 3.15 per cent, a level Neumann described as “very attractive” on a relative basis.

“That’s an EM-type yield – it’s not without risk, but it’s got to be pretty interesting. I understand why people are looking at QFIIs and are wanting to get into the market,” he told Hedgeweek on Thursday.

Neumann said FTSE Russell’s decision does not necessarily force the participation of the alternatives managers, since as most of them are non-benchmark.

“At the fringes, though, some of them are benchmark-aware, especially at the more systematic part and liquid end, where they need to be in something if it’s a major part of a benchmark. That may mean more participation.

“But I think the key thing is what the return generation, or alpha generation, opportunities are within fixed income and rates, and even FX,” Neumann said. “That part of it is interesting.”

Neumann, who earlier traded US government bonds for some 15 years, flagged potential liquidity challenges in times of dislocation, which could dissuade some potential investors who are more used to trading more liquid government bonds.

“Access and liquidity are always the two hurdles you have to get over,” he said. “But there has to be opportunities there for the macro funds, the fixed income funds and even for those who are more benchmark-driven.”

He compared the growing focus and momentum on China in recent years with the rise of ESG (environmental, social and governance) investing, which has been a hot topic of conversation among industry participants lately, but without necessarily any meaningful movement – until now.

“It started with the A-shares market and equities, and it’s now broadening out with government bonds and corporate bonds,” he said, pointing to certain systematic managers that predominantly trade futures being “very interested” in accessing the Chinese market. 

“I know that on the hedge fund side there are now a number of Chinese-only investment vehicles, meaning that only domestic Chinese investors can access them but they’re run by non-Chinese domiciled entities.

“Adding more assets to your stable means more return opportunity, but also the ability to raise more AUM as you have more places to put the money, not just in bonds but equities as well.”

Meanwhile, Man’s commentary also highlighted a “firmly negative correlation” between stocks and bonds and noted that China stands out as “a particularly promising destination for risk parity strategies.”

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