(Bloomberg) -- A money-market squeeze, capital controls and shrinking foreign-currency reserves may make it difficult for investors to be bullish on Chinese bonds. Not UBS Asset Management.
The money manager is not only betting on a rally in yuan-denominated notes in the second half of 2017 but also expects an upturn in foreign-investor interest that could double the size of the $9 trillion market in five years, according to Hayden Briscoe, the head of fixed income for Asia Pacific. There's one caveat: don't do anything just yet.
"We are witnessing the biggest change in the history of capital markets," Briscoe said in an interview in London on Jan. 30. "The government is carrying out reforms at breakneck speed. None of us can afford to ignore this market anymore."
Foreigners own a mere 3% of China's local-currency bonds, whose size equals a fifth of the Bloomberg Barclays Global Aggregate Index, a $45 trillion benchmark. A year after the nation opened the market to most types of overseas investors and the currency qualified for reserve status, the take-up trails estimates as investors remain concerned about the government's control of capital outflows.
Briscoe is still cautious in the short term. Sovereign bonds are heading for a fourth month of losses, and are lagging behind emerging-market peers by the most since November 2014. The central bank is curbing excessive leverage by ordering lenders to control new loans, setting limits on mortgages and increasing interest rates on medium-term loans.
These measures, while bringing pain now, will prove to be "bond-positive" in the latter part of the year, Briscoe said. Tighter financial conditions will lead to a slower economic growth and prompt officials to adopt a "looser" monetary policy, he said. But further impetus will come next year, when the bonds get included in global benchmark indexes, unlocking billions of dollars in fund flows, he said.
The Communist Party of China will hold its 19th National Congress in the fall. This once-in-five-years affair will see leadership changes, a consolidation of power by President Xi Jinping. As politicians jockey for positions, the focus is shifting to politics, holding up new investments, Briscoe said.
Briscoe said Chinese bonds will be included in major indexes "fully" by next year, a move that will push money managers to reallocate funds to the market. UBS is not alone: BlackRock, the world's largest money manager, and Pimco also expect the move by 2018.
The country may eventually occupy at least 33% of indexes provided by JPMorgan Chase, Citigroup Index and Bloomberg Barclays Indices, according to a report last year. A 5% - 8% weighting in Citigroup's gauge would spur passive inflows of as much as $160 billion, according to a Standard Chartered estimate.
Yet investors remain unmoved.
Overseas funds sold a net $277 million of the bonds in January, according to China Central Depository & Clearing, amid surging interbank borrowing costs, quickening inflation and expectations for a weaker yuan.
Investors also face obstacles like unclear tax rules and a lack of currency hedging tools. Briscoe said the government is "reforming at record pace" and the removal of bottlenecks is a matter of time.
This year may also see an increased shift by China's provincial governments from bank loans to borrowing in bonds as a result of a move mandated by the federal government, Briscoe said. Bonds currently account for 12% of financing, with 68% coming from loans.