By Ingrid Melander
LONDON Aug 10 (Reuters) - Sovereign wealth funds are increasingly interested in buying China's domestic bonds to get a bigger foot in the world's second largest economy, benefit from good yields and diversify their exposure to more currencies.
Despite concerns over China's slowing growth, the giant industry, which manages countries' windfall revenues for future generations, is taking advantage of the gradual opening up to foreign investors of its mainland bond market worth over $3 trillion.
Norway's sovereign wealth fund said on Friday it had increased its exposure to Chinese government bonds, had already reached the ceiling of its quota for onshore Chinese assets and was seeking to increase it.
"The onshore Chinese market is bigger than the (German) bund market, bigger than the (UK) gilt market and these guys have hardly any exposure to onshore renminbi," said Gary Smith, global head of official institutions at BNP Paribas Investment Partners. It "is something they are very very keen to be involved with."
The domestic, so-called "onshore" market is a highly-regulated market for yuan-denominated sovereign and corporate bonds providing limited access for foreigners, with only a restricted number of overseas institutional investors allowed to buy. It offers a much bigger pool of assets than bonds traded freely outside of mainland China in the so-called "offshore" market.
Sovereign wealth funds, whose assets are estimated at $3-4 trillion, are increasing their exposure to emerging markets in their hunt for better returns in the midst of the euro zone's debt crisis and slowing global growth.
They can buy into China's domestic bond and equities market through its Qualified Foreign Institutional Investor (QFII) system of licenses and quotas, which Beijing loosened on July 27 when it published new rules that allow investment in the interbank market, where most bonds trade.
This follows moves to grant more licences and increase the quota for the overall QFII programme from $30 billion to $80 billion earlier in the year, and comes after China began allowing foreign central banks in 2010 to directly invest in its domestic interbank bond market, outside the QFII system.
"Sovereigns in general are underexposed to Chinese assets and given the flat equities in China and decent yields you can get on bonds they are diversifying into that," said Andrew Economos, head of sovereign and institutional strategy for Asia at JP Morgan Asset Management.
Chinese bonds offer yields from 4 percent to double-digits depending on the quality, with sovereigns more interested in the lower-yielding, higher quality ones, he said.
"We have seen more and more sovereign fund requesting quotas and increasingly they are receiving licenses," he said. "It has been occurring, rather selectively but with increased frequency."
Asian sovereigns understand the Chinese opportunity better and have shown more interest, with European and Middle Eastern ones following now, Economos said.
JPMorgan Asset Management is, together with BNP Paribas, among the 172 financial institutions which had a licence to buy Chinese securities through the QFII system as of end June.
Some of the world's largest sovereign wealth funds, Abu Dhabi's Investment Authority and Singapore's GIC have such licences to buy Chinese bonds themselves without going through asset managers.
Qatar has applied for a $5 billion quota in the QFII scheme, the official China Securities Journal reported in June.
Among central banks, Bank Indonesia has started investing in China's interbank bond market and on July 1 the official Xinhua news agency reported that Korea had begun making purchases. Neither have said how much they were buying.
"We do have a lot more interest from other central banks and sovereign wealth funds," said Becky Liu, Hong-Kong based HSBC Asian fixed income strategist, adding that she could not mention names for confidentiality reasons.
"The domestic market has been opening up much faster this year, and has therefore attracted much more interest from foreign investors," said Liu, adding that on top of direct purchase by central banks, "some countries prefer to buy from the sovereign wealth funds."
China's main bond clearinghouse publishes a data series widely considered to be a proxy for foreign holdings of Chinese interbank bonds. That figure stood at 96 billion yuan ($15 billion) at the end of June, up from 87 billion yuan at the end of 2011, out of a total of 22 trillion yuan of outstanding bonds in China's interbank market.