(Bloomberg) -- Global investors boosted their holdings of Chinese bonds to a record last month, taking advantage of a market anomaly that allows a premium when swapping dollars into the yuan.

Foreign funds held 4.22 trillion yuan ($582 billion) of onshore yuan bonds in the interbank market at the end of May, according to data from the People’s Bank of China. Most of the purchases were in short-term bank debt — a favored instrument for swap strategies — while government bonds saw year-to-date outflows, Bloomberg calculations show. 

Overseas funds have boosted their holdings of Chinese debt since late 2023, a marked shift from 2022 when pessimism toward the nation’s assets and a US yield premium led to a mass exodus. Despite lingering geopolitical risks, a dollar shortage onshore and the US-China interest-rate divergence has created a market condition that gives higher currency-hedged yields for Chinese debt over US Treasuries. 

“The dollar shortage and subsequent widening basis generates good asset-swap spread trading opportunities,” fueling inflows into banks’ negotiable certificates of deposit, said Kiyong Seong, lead Asia macro strategist at Societe Generale in Hong Kong.

Chinese bonds may also be receiving more allocation amid a recovery of global foreign-exchange reserves as well as a moderate increase in global bond fund assets, he said.  

A trader who exchanged dollars for the yuan in China’s onshore swap market and invested in one-year NCDs — a short-term debt instrument issued by onshore banks — could obtain a held-to-maturity return of around 90 basis points above that earned from US Treasury bills, according to calculations by Bloomberg based on end-May prices. 

Despite a nine-month run of net purchases that’s led to the record holding, overseas investors accounted for just 3% of outstanding interbank bonds as of May, based on data from the People’s Bank of China. 

Global funds have cut their holdings of Chinese government bonds this year, while their purchases of NCDs have surged. NCDs accounted for 21.1% of the total foreign holdings in the interbank market at the end of last month, versus 5.9% a year ago, according to Bloomberg calculations.  

Future demand for Chinese bonds is likely to differ among investors, according to Societe Generale. Allocation demand associated with foreign-exchange reserves “could see downside risk ahead of the US election,” although there should be more inflows into shorter-maturity bonds with the asset swap trade, Seong said. 

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