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As international geopolitical risks continue to escalate, bond carry trades remain active, and global financial market volatility increases sharply, more and more foreign capital is increasing its holdings of domestic bonds.

The operation status of overseas business in the interbank bond market in July released by the China Foreign Exchange Trade System showed that overseas institutional investors bought 1092.4 billion yuan (denominated in RMB, the same below) of bonds and sold 864.1 billion yuan of bonds, with a net purchase of 228.3 billion yuan.

It is worth noting that the settlement agency model is still one of the main channels for foreign capital to increase its holdings of RMB bonds. Data shows that in July, foreign capital completed RMB bond transactions of 899.4 billion yuan through the settlement agency channel (835.7 billion yuan in agency transactions and 63.8 billion yuan in direct transactions), with a net purchase of 156.3 billion yuan; through the Bond Connect model, RMB bond transactions of 105.7 billion yuan were completed, with a net purchase of 72 billion yuan.

"Behind this is the fact that allocations mainly consisting of overseas long-term capital such as foreign central banks and sovereign wealth funds prefer to increase their holdings of domestic bonds through the settlement agency model. In comparison, trading accounts mainly consisting of hedge funds and overseas wealth management products are keen to operate interest rate carry transactions through the Bond Connect model." A domestic private equity fund bond trader revealed to reporters.

The so-called bond spread trading is mainly affected by factors such as the continuous rise in domestic bond prices and the imminent pace of the Federal Reserve's interest rate cut, which has left a large room for the appreciation of the RMB exchange rate. After conducting forward exchange rate hedging operations against the US dollar against the RMB in the foreign exchange market, many foreign capitals have increased their holdings of short-term Chinese government bonds and interbank certificates of deposit. This is because they believe that the actual investment return rate of the above operations will be higher than that of US government bonds in the same period.

The domestic private equity bond trader pointed out that as the Federal Reserve released a signal of a rate cut in July, coupled with the financial market's expectations that China would continue to cut interest rates and reserve requirements (causing domestic bond prices to rise), more hedge funds and overseas wealth management products increased their holdings of short-term treasury bonds and interbank certificates of deposit through the Bond Connect Northbound channel that month, causing the Bond Connect transaction volume in July to exceed one trillion yuan.

Many industry insiders pointed out that as overseas capital allocation and trading continue to be active, coupled with the increasingly prominent safe-haven properties of domestic bonds, the monthly scale of overseas capital increasing its holdings of domestic bonds will remain at a relatively high level in the future, laying a more solid foundation for the continued smooth operation of cross-border capital flows.

Overseas capital allocation and trading are both "active"

Many industry insiders pointed out that since July, overseas capital investment in domestic bonds has shown an active trend in both allocation and trading.

In terms of allocation, as the Federal Reserve released a signal of interest rate cuts, the interest rate gap between China and the United States narrowed from -200 basis points to -170 basis points, and as international geopolitical risks continued to escalate, more and more long-term capital such as foreign central banks and sovereign wealth funds have regarded Chinese government bonds and policy financial bonds (policy financial bonds) as important safe-haven assets, and increased buy-and-hold operations.

Jiang Huifen, deputy director of the Financial Markets Department of the Central Bank, said earlier that RMB bonds have a high value of diversified investment, and their risk aversion function is constantly increasing. The yield of RMB bonds is less correlated with the bond yields of G7 countries and other emerging economies. It is estimated that the yield correlation between the 10-year treasury bonds of China and the United States in 2024 will be only 0.05.

An emerging market investment fund manager analyzed that in July, foreign central banks, sovereign wealth funds and other institutions still accounted for half of the net purchases of Chinese bonds, highlighting the growing demand for safe-haven assets among global long-term funds, which continued to benefit China's high-credit-rated government bonds and financial bonds.

In terms of trading, since July, overseas hedge funds and wealth management products have been "increasingly interested in bond interest rate spread trading."

Yu Lifeng, an analyst at the Research and Development Department of Orient Securities, said earlier that at the end of June, based on the USD/RMB exchange rate and the 1-year exchange rate swap transaction point price, the comprehensive yield obtained by overseas capital buying 1-year Chinese government bonds and signing 1-year forward exchange rate swap contracts reached 5.85%, higher than the US 1-year Treasury bond yield (4.36%).

The reporter learned that this has driven more and more overseas hedge funds and wealth management products to increase their investment in bond spread transactions. Especially in mid-to-late July, after the 1-year Treasury bond yield once fell below the 1.5% integer mark, many overseas hedge funds and wealth management products turned to investing in short-term interbank certificates of deposit with an annualized return rate of about 2% to increase the return rate of bond spread transactions.

The above-mentioned private equity bond trader revealed to the reporter that as the RMB exchange rate against the US dollar has risen from 7.2776 to around 7.133 since late July, the exchange rate return of the RMB appreciation has been rising, coupled with the expectation of a 50 basis point interest rate cut by the Federal Reserve in September (causing a larger correction in the US dollar index), more foreign capital is increasing the leverage of bond interest rate spread transactions. At present, the leverage ratio of some hedge funds in this investment has been increased from 2 to 3 times at the end of the first quarter to the current 3 to 4 times.

Behind the “rising tide” in trading volume

It is worth noting that the continued activeness of overseas capital allocation and trading has also driven a surge in the scale of overseas capital transactions in the Chinese bond market.

Data released by the China Foreign Exchange Trade System showed that in July, overseas institutional investors completed a total of 1.9565 trillion yuan in spot bond transactions, an increase of 58% year-on-year and 24% month-on-month. The trading volume accounted for about 6% of the total transaction volume of the spot bond market during the same period.

In that month, overseas institutional investors traded a total of 195.1 billion yuan during the extended trading hours, accounting for approximately 10% of the overseas institutional trading volume during the same period.

"Behind this, on the one hand, some overseas hedge funds and wealth management products have chosen to take profits as the RMB exchange rate has rebounded sharply and short-term bond prices have risen, and on the other hand, more overseas investment institutions are either scrambling to join the bond spread trading camp or simply buying and holding until maturity." The above-mentioned emerging market investment fund manager pointed out. In particular, the money-making effect of bond spread trading has become increasingly prominent, attracting a large amount of overseas capital to capture the arbitrage opportunities of the spread trading between short-term government bonds and interbank certificates of deposit.

The reporter noticed that in the northbound channel of Bond Connect, where bond interest rate spread transactions are concentrated, the average daily trading volume of foreign capital reached 46 billion yuan in July. Among them, transactions in government bonds and treasury bonds were particularly active, accounting for 43% and 35% of the monthly trading volume respectively.

Specifically, in terms of the distribution of the size of single transactions in the secondary bond market, 33% are small bond transactions of less than 10 million yuan, and 15% are large bond transactions of more than 200 million yuan.

In terms of maturity, short-term government bonds with a term of less than one year and medium- and long-term government bonds with a term of 7 to 10 years are the most actively traded, accounting for 37% and 34% respectively.

The emerging market investment fund manager believes that behind this, it shows that overseas hedge funds and wealth management products are expanding the scale of bond interest rate spread trading through the northbound channel of Bond Connect, while also capturing trading profit opportunities brought about by the rising price trend of medium- and long-term government bonds.

It is worth noting that while more and more overseas investment institutions are increasing their holdings of medium- and long-term treasury bonds and waiting for them to rise in price, they are also increasingly concerned about the risk of falling treasury bond prices (and a corresponding sharp rise in treasury bond yields) brought about by the People's Bank of China's entry into the market to sell long-term treasury bonds, and are locking in the market risks of their long-term treasury bond holdings through swaps.

Data shows that in July, a total of 572 northbound swaps were completed, with a nominal transaction amount of RMB 300.74 billion, and the total number of overseas institutions entering the market increased to 63.

"In actual operations, there may be more overseas investment institutions that hedge domestic government bond interest rate risks and market risks through the Northbound Swap Connect. The reason is that many overseas hedge funds and wealth management products have relatively small capital scales, so they simply rely on the operating channels of large overseas investment institutions and use the Northbound Swap Connect to complete the market risk hedging process of the bond interest rate spread trading strategy holding process." The aforementioned emerging market investment fund manager pointed out.