GLOBAL funds are taking advantage of the higher yields available on the Chinese mainland compared to Hong Kong as China opens its bond market to finance a surging budget deficit.

Foreign investors held 184.8 billion yuan (US$29.7 billion) of bonds on the mainland as of February 28, double the figure a year earlier, according to Bank of America data. Government debt holdings tripled to 41.6 billion yuan. The 10-year sovereign yield is 3.58 percent in Shanghai, compared with 3.03 percent for similar-maturity Dim Sum securities in Hong Kong and 1.93 percent for US Treasuries.

Premier Wen Jiabao this week pledged to expand cross-border use of the yuan and encourage foreign investment as it allows a 50 percent jump in the deficit to 1.2 trillion yuan to spur the economy.

Lombard Odier Investment Management has shifted part of its China allocation to Shanghai bonds from offshore debt because of higher yields, a wider selection of issuers and more active trading.

"Our preference would be to use the Chinese market," said Stephane Monier, deputy global chief investment officer at the Geneva-based fund manager. "The Dim Sum market will lose some of our interest as we get more access to China."

Lombard is favoring shorter-dated debt in emerging markets that are less vulnerable to inflation and can benefit from currency appreciation, Monier said, adding that his company is considering a new fund focused on these securities.

China introduced the Qualified Foreign Institutional Investor program in 2002, allocating quotas to non-Chinese funds that were initially restricted to trading stocks and bonds listed on exchanges. In July 2012, the authority allowed QFII to enter the interbank market, which hosts 99 percent of the nation's debt.

Regulators had approved a combined QFII quota of US$40 billion as of January 31 under the program. That's up from US$36 billion as of November 30. Lombard Odier invests in China's onshore bonds through QFII, Monier said.

Authorities also eased limits on investment by sovereign wealth funds and foreign central banks. It has also expanded the so-called Renminbi Qualified Foreign Institutional Investor program, allowing Hong Kong units of Chinese banks and insurers and financial institutions registered in Hong Kong to market products that enable offshore yuan to be invested domestically.

Offering attractive rates

More foreign investors in China's bond market will help absorb the additional sales as the government looks to reduce companies' reliance on bank loans to sustain economic growth, according to Steve Wang, Hong Kong-based head of fixed-income research at BOCI Securities Ltd.

"In such a low-yield environment globally, the Chinese bond market is offering attractive rates," he said. "The liquidity is better and you have more choices than the offshore market. The onshore interbank transaction costs are possibly lower given it's an electronic platform, while the Dim Sum bonds have over-the-counter trading."

The 10-year government yield was little changed this year at 3.58 percent, according to Chinabond data. The bond yield may climb 12 basis points to 3.70 percent by year-end, according to the median forecast in a Bloomberg News survey of nine Chinese finance firms after Wen outlined 2013 economic policy this week.

China has "obviously" tightened monetary policy since the peak of the financial crisis, People's Bank of China Governor Zhou Xiaochuan said during the National People's Congress meetings in Beijing.

Monetary policy is "stable overall" and able to support the nation's economic growth target for this year, Zhou said.

Premier Wen committed to spending on roads, subways and low-cost housing to accelerate China's urbanization and achieve a growth goal of 7.5 percent this year.

"Supply and demand is one of the key interest-rate drivers but in my opinion the monetary policy remains the key market driver," Paula Chan, a Hong Kong-based fund manager at Manulife Asset Management.

"I hold a neutral to slightly bearish view on the government bond market as I believe there is a risk for PBOC to hike rates later this year due to potential inflation risk."

She predicts the 10-year yield will climb to 4 percent by the end of the year. Manulife's Hong Kong unit has a US$300 million QFII quota, according to SAFE.

The flow of funds into China is unlikely to slow growth of Hong Kong's bond market. Yields on the Dim Sum sovereign due June 2022 declined 41 basis points since its high in September.

HSBC Holdings Plc estimated in a January report that sovereign issuance of Dim Sum bonds focused on foreign investors in Hong Kong will rise to 30 billion yuan this year, from 22 billion yuan in 2012.

Foreign investors could be disadvantaged in terms of information flows as the onshore market is dominated by local banks and sensitive to rumor-driven events, BOCI's Wang said.

"For foreigners, they are not familiar with the China bond market," said Chris Lau, a bond manager in Hong Kong at Bosera Asset Management Co. "At an initial stage of investment, most of them would only focus on the government bond, bonds issued by policy banks, PBOC bills or AAA-rated bonds issued by some large and well-known state-owned companies."

Insuring sovereign notes

The yield on 10-year top-rated corporate bonds fell 18 basis points in the past year to 5.18 percent, according to Chinabond.

Bond risk for the nation has dropped this year. The cost of insuring China's sovereign notes using five-year credit-default swaps fell four basis points to 62 in New York this year, according to data provider CMA. The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent if a government fails to adhere to debt agreements.

The People's Bank of China and domestic financial institutions sold a record 683.7 billion yuan to buy foreign exchange in January, a gauge of capital inflows.

"China's bond market will continue to attract interest as it is impossible for international investors to ignore the big market of the future," said Wee-Ming Ting, Singapore-based head of Asian fixed income at Pictet Asset Management.