LONDON (Reuters): China's US$16 trillion bond market is the proverbial elephant in the investment room. But it's becoming too big to ignore, even for the most risk-averse Western investors.
A large, A+ rated market that pays 3% yields, with minimal volatility? It's looking increasingly alluring for European pension funds swimming in sub-zero bond yields as aging populations stretch their finances.
For some, the benefits are beginning to outweigh the political risks, and they are upping allocations to China, or considering doing so, according to Reuters' interviews with half a dozen firms that advise and manage money for pension funds.
"Not all our clients invest in China's bond market, but they are all looking into it," said Sandor Steverink, head of Treasuries at APG, which manages a third of the assets of the 1.5-trillion-euro ($1.8 trillion) Dutch pension industry.
Dutch 10-year bond yields are languishing at around -0.4%, spelling losses for any investor who holds them to maturity, a picture reflected across Europe.
Such fund interest is a boon for Beijing, which is seeking to internationalise its financial markets and lure big-ticket overseas investors as its once-mighty trade surpluses dwindle. Europe's pension industry alone is worth $4 trillion.
China's sovereign debt market is the world's second-largest after the United States. Yet while foreigners own a third of the U.S. Treasury market, they hold just 9.7% of China's sovereign debt, according to government data.
Western pension funds make up a tiny cohort of the foreign investors in yuan bond markets, but their presence is growing.
Of the $9.5 trillion of assets under management from corporate and public pension funds globally, 0.26% was held in Chinese bonds as of the third quarter of 2020, up from 0.04% in 2015, according to data from institutional asset managers shared with financial data provider eVestment.
Beijing's drive to draw foreign money has taken a whack of late as tensions with the United States have resulted in the ejection of several Chinese companies from U.S. equity indexes and curbs on U.S. government pension funds investing in China. There have also been defaults by state-owned firms.
Investors also cite potential pitfalls such as less market transparency and liquidity, with some Japanese investors protesting China's inclusion into FTSE Russell's World Government Bond Index.
In addition, some say the country still has further to go in opening up its markets and worry that while capital controls, which made repatriation of profits difficult, have been eased, they could also be tightened.
China's relatively successful handling of the Covid-19 crisis and brighter economic prospects has buoyed confidence, though.
APG runs around 100 million euros in a local Chinese bonds strategy it started just over a year ago. Steverink acknowledged that political risks gave clients "cold feet", but predicted that would change as more cash swept into the debt.
"You have to explain if you invest in China. You don't need to explain if you don't invest. That's how it is for the time being," he said.
"In the decades to come, it will be the other way around."
Pension funds themselves are famously secretive about their investment allocation trends, and more than two dozen contacted by Reuters, mostly European, declined to comment on this.
However, their money managers, and certain central banks that track investment flows, can provide a window.
China has only stepped up efforts to open up bond markets in the past decade, so foreign investment is starting from a low base. While an increase in broader investment interest is not a new phenomenon, pension funds -- the biggest and most cautious players -- are now beginning to go with the flow.
The investors interviewed by Reuters said 2020 had been a watershed year, with more developed world bond yields collapsing into negative territory on the back of massive monetary stimulus, combined with China relaxing restrictions on foreign investment.
Insight Investments is looking into setting up a Chinese bond fund on behalf of UK pension funds, Sabrina Jacobs, a fixed-income investment specialist at the $1 trillion asset manager told Reuters.
She declined to give details to protect the anonymity of her clients but said her company, part of the BNY Mellon Group, had also been asked by other UK and European-based pension funds to explore Chinese debt investment.
Jacobs said China met many of the criteria pension investors had when investing overseas - besides size and credit ratings, the yuan is less volatile than other emerging currencies.
Essentially, that means daily swings with the potential to wreck returns are less common; in fact yuan volatility is lower than some G10 currencies such as the Australian dollar.
Jacobs also said Chinese markets moved less in tandem with global peers.
"While you have a very high correlation between, say (German) Bunds and Treasuries, Chinese government bonds are only 15 to 20% correlated to other bond markets, the big ones globally. So, it is an attractive diversifier as well."
Insight currently holds around $400 million of Chinese debt within its emerging market and global government bond funds.
Some other investors who allocate funds on behalf of European pension fund clients, including Pictet Asset Management and Willis Towers Watson, also said they were seeing more interest in Chinese bonds from the pension industry.
Pictet, with assets of $600 billion, does not break down flows by investor type but said inflows to its Chinese bond fund had risen from $144 million to $770 million in 2020.
Shaniel Ramjee, part of Pictet's multi-asset team, is confident that Chinese debt has moved past being a niche asset for large institutions like pension funds, but said the trend was in its early stages.
"We haven't seen those dedicated allocations come through in large amounts yet, so there's a lot further to go on this," he added.
Dutch pension funds held 22.4 billion euros in overall investments in China as of the third quarter of 2019, mainly in stocks, with just 300 million euros in bonds, the Netherlands central bank said. That's up from 200 million euros in bonds in 2017.
Latest available data from Germany's central bank shows that German funds, including pension funds, invested a total of 2.5 billion euros in Chinese bonds in November 2020 alone, a 62% rise from the same month a year earlier.
Sweden's AP2, a national pension fund and a rare example of one that publishes its allocation to China, has had a stable 1% allocation to Chinese government bonds since 2017. It manages roughly $43 billion of assets.
China, for its part, needs overseas pension money as its shift towards a consumption-driven economy has diminished its trade surpluses.
Pension money also has a particular cachet, because of size - retirement savings in the top 22 economies currently top $45 trillion - and its "sticky", long-term nature.
All this has motivated China to smooth access to its markets, enabling its bonds to join high-profile debt benchmarks compiled by FTSE Russell and Bloomberg/Barclays.
China's interbank bond market regulator did not respond to requests for comment on foreign pension fund holdings in Chinese bonds.
Data from the Central China Depository & Clearing Co (CCDC), shared with Reuters, shows almost 200 foreign funds had invested in Chinese bonds as of end-September via the China Interbank Bond Market (CIBM), 42% above year-ago levels. The CCDC does not compile specific data on pension fund flows.
"Pensions funds say they are now looking hard at China as an alternative," said Robin Marshall, FTSE Russell's director of bond market research. "They would not have looked at it a few years ago."