Tax change lures foreign investors to China policy-bank bonds

As China opens up its $12 trillion bond markets to offshore investors, a recent tax change is tempting foreign money to look beyond just the safest government bonds and to debt issued by the country's policy banks. Official data shows foreign money is trickling into bonds issued by the state-owned policy lenders such as China Development Bank (CDB) and the Export-Import Bank of China, and offshore investors say they are considering further investments in these bonds.
Known as policy-bank bonds, these instruments offer higher yields than debt issued by the central or top-rated local governments. But foreigners have had to pay taxes of as much of 16 percent on their income from bonds, with the exception of outright government debt.
Beijing changed that calculus last month, saying it would waive taxes for offshore investors in China's domestic bond market for three years, though it didn't specify when the tax change would take effect. "We have increased our exposure to policy banks over the last three months." said Jean-Charles Sambor, deputy head of emerging market debt at BNP Paribas Asset Management, whose team manages $3.5 billion of investment.
"We think that it's a nice yield pickup with no additional credit risk compared to central government bonds. And now that the taxation regime has been clarified, it will be positive." For now, BNP is just one among the relatively few large investors increasing exposure to policy bank bonds. Several others are waiting for clarity on the recent tax changes.
CDB's 10-year bonds yielded 4.2680 percent on Friday, compared with 3.655 percent for 10-year sovereign bonds, according to Thomson Reuters data. A 16 percent tax eliminates that yield premium. Offshore investors held 330.6 billion yuan worth of policy bank bonds in August, mostly issued by CDB, according to data from China Central Depository and Clearing Co., up just 3 percent since the end of 2017.
In contrast, offshore investors held 1.03 trillion yuan worth of central government bonds, 70 percent more than at the end of 2017. CDB, China's policy lender responsible for large infrastructure investment at home and overseas, is the biggest issuer of the three policy banks, with 7.75 trillion yuan worth of bonds outstanding in the onshore market, according to Thomson Reuters data.
It has A+ long-term issuer ratings from agencies Fitch and S&P, equal to China's sovereign rating. Investors say that the tax change has refocused attention on policy bank bonds, especially as the Bloomberg Barclays Global Aggregate Index gradually includes Chinese government and policy bank bonds from April 2019.
Hayden Briscoe, head of Asia Pacific fixed income at UBS Asset Management, said offshore investors were just starting to increase their portfolio allocations to policy bank bonds from a low base. "This is the start of the institutional flow you're starting to see now," in contrast with sovereign wealth funds and central banks, which typically invest in government bonds, Briscoe said.
The bonds also benefit from being highly liquid. National Interbank Funding Center data showed that policy bank bonds made up 35 percent of bond trading volumes in August, compared with 13 percent from treasury bonds. The six most-traded bonds in China's interbank market in August were issued by CDB.