Dim sum bond investors betting on the appreciation of the renminbi have been willing to sacrifice protection for exposure. Stefanie Eschenbacher asks if they are being compensated for the risk.
The emotional and permissive goodbye from China’s premier Wen Jiabao in Beijing in March left many people wondering what the future holds for the country.
After the last parliamentary session of the National People’s Congress before a leadership change, he talked about “many regrets”, “obstacles” and missed opportunities. Wen pressed for further political and economic reforms, warning that otherwise the gains China made in the past decade may be lost.
Most of these gains were the result of China’s first major market-oriented reforms initiated in 1978, which the International Monetary Fund once called “an effort to awaken a dormant economic giant”.
Today, there is little doubt that the economic giant is wide awake and restless.
Demand for its dim sum bonds – named after the bite-sized Cantonese speciality – has been huge since the market was created in 2007.
Still volatile and illiquid, the dim sum bond market is for most investors the only viable option to diversify their currency holdings into renminbi.
Diversification was a reason to buy dim sum bonds, no doubt, but it was the potential appreciation of the renminbi that made the investment case so compelling.
Issuance of dim sum bonds amounted to $17,943.8 billion last year, according to Thomson Reuters, up from $5,947.7 billion The number of issuers increased from 23 to 113.
Until the end of February, $2,594.6 million had already been raised by 22 issuers. Fitch Ratings predicts a full year issuance of $37,343 million.
Major international corporates have also started to issue dim sum bonds. The McDonalds Corporation issued the first in August last year and since then, Caterpillar, Unilever, Volkswagen and Tesco have followed suit.
This year, 13 foreign banks and corporates issued dim sum bonds debt in Hong Kong so far. Those include Korea’s Lotte Shopping, Mexico’s America Movil, Germany’s Lanxess and, most recently, Ford in the UK.
Quality and risk
Of the 39 Chinese corporates that issued dim sum bonds last year, however, only seven have an international rating.
Investors are becoming concerned about the lack of protection and the poor level of operational disclosure, compared with that of a typical dollar high-yield bond.
The asset management team at Bank of China (Hong Kong) has developed its own credit rating process, factoring in credit quality and default risk.
“To be a successful fund manager, we need to be ahead of market developments,”
says Hu, the deputy chief investment officer and head of fixed income.
“We are not just focusing on currency appreciation, but also managing credit quality and default risk,” he adds.
Yu-Ming Wang, a senior managing director and head of fixed income, Asia, at Manulife Asset Management, says the perception that Asia is riskier than other markets is “a dated concept”.
Wang highlights a time in December last year where France’s credit default swap rate was ten basis points above Indonesia’s. “The lack of information in Asia pulls international investors back to the familiar, their home markets,” he says.
Wang and his team use international credit ratings for reference. Investment decisions, however, are made based on a fundamental analysis of the companies.
There are six credit rating agencies in China, one of which is the Dagong Global Credit Rating. Until August last year, it had been overlooked by international investors, who continue to rely on ratings from Moody’s, Standard & Poor’s and Fitch.
In what many considered a bold move, Dagong downgraded US sovereign debt from A+ to A and assigned a negative outlook. This put the United States five notches below the AAA rating and on the same level as Russia.
“Local ratings agencies have yet to establish their credibility and have yet to get sufficient history,” Wang says. “In the absence of such ratings, knowing the fundamentals of a company is key. Some funds are mandated to hold only bonds with a certain rating issued by an external ratings agency,” he says, adding that the introduction of ratings would also diversify the investor base.
Matt Jamieson, the head of Asia Pacific research at Fitch Ratings, says the dim sum bonds lack the covenants that investors would expect to see in offshore dollar high-yield bonds from the same issuers. “These are unknown names, which means a higher risk of default.
But fixed income investors buy them anyway,” he says. “Most are not even worrying about yield because they are too fixated on currency appreciation.”
Another risk is the illiquidity of the dim sum bond market. Most investors buy these bonds to hold them, rather than trade, because they seek currency appreciation.
Jamieson says sufficient investor interest needs to be shown for longer term maturities, as opposed to the current “currency play” that drives the acceptance of short-term maturities.
Teresa Kong manages the Matthews Asia Strategic Income fund for Matthews International Capital Management, for which she selects government and corporate bonds from various Asian countries.
“The dim sum bond market is still characterised by bonds with short-term maturity,” she says. “While there are some with five-year maturities, or even seven, a maturity of three years is the sweet spot.”
Only 9% of dim sum bonds issued last year and 3% this year have a maturity of longer than three years. The exception is the 15-year issuance by China Development Corporation in January and the Chinese Government in August last year.
About a quarter of the bonds will mature either this year or next year when some of the Chinese corporates might have trouble accessing cheap financing to repay their debt.
While there have not been any technical defaults in the dim sum bond market to date, some sectors are showing signs of stress, such as the bulk container industry owing to oversupply.
“Because the market is premature, it is hard to see default trends,” says Jamieson, adding that those corporates connected to the Chinese government should be less risky.
Even though yields on dim sum bonds have surged in recent months, the question remains whether they are high enough to compensate for the risk.
Dim sum bond yields remain lower than those in the Chinese mainland. The five-year Chinese government bond, for example, yields 2% in Hong Kong and 3.3% in Shanghai.
The asset management team at Bank of China (Hong Kong) can invest in both onshore and offshore bonds. Hu manages the RMB fund and the RMB High Yield Bond fund.
Hu says some high-yield bonds traded offshore offer more attractive yields than those traded onshore market, even if they were issued by the same company.
Kong shares this line, adding that the onshore market does not compensate investors for the risk they are taking.
Guanzhou R&F Properties, for example, has two renminbi bonds with maturities both in 2014. Earlier this year, the onshore bond traded at a market yield of 6.8% per year, while the dim sum bond traded with a much higher yield of 14.5%.
Hu says the higher yields in the offshore market were largely because of a heavy sell-off by foreign investors as they needed to repatriate capital back to their home countries.
Other high credit quality non-government bonds with maturiries of five years or above offer similar yields.
When China Development Bank issued its 15-year dim sum bond in the offshore market in January, Hu says its issue yield of 4.2% was largely based on the market yields of its long maturity bonds in the onshore market.
Investors have come to realise that bonds listed in China are highly sensitive to the government’s monetary policy.
Wang says the offshore market was down by 2% last year, when stripping out the appreciation of the renminbi, while the onshore market was up by 3%.
In the first half of last year, the yield curve for the onshore market rose because of high inflation. Then the yield curve fell because of China’s monetary policy response.
This focus on yield and credit quality suggests the market is maturing and investors are looking beyond currency appreciation.
The renminbi has already appreciated against the dollar on a real, inflation-adjusted basis reaching nearly 12% since June 2010 and nearly 40% since China first initiated a currency reform in 2005.
Outgoing Chinese premier Wen said in March that the real effective exchange rate for the renminbi might already have reached its equilibrium.
Whether the renminbi is still undervalued and, if so, by how much is a contentious point.
Paul Krugman, who won the Nobel Prize for Economics in 2008 for his work in international trade patterns, has often labelled China a “currency manipulator”.
America’s Peterson Institute for International Economics claims the renminbi “needs to rise by about 20% on a trade-weighted average basis and by about 40% against the dollar”.
In its latest semiannual report on international economic exchange rate policies, the US Treasury states “the real exchange rate of the renminbi is persistently misaligned and remains substantially undervalued, though the degree of this undervaluation appears to have declined recently”.
Pressure on the Chinese government to let the renminbi appreciate has mounted in recent years, especially after the financial crisis. Other major export countries accused China of running a currency policy that gave it an unfair advantage on the world market, threatening a currency war.
Christine Lagarde, managing director at the International Monetary Fund, called for “a stronger and more flexible exchange rate” at the China Development Forum 2012 in Beijing in March.
Another contentious point is whether the Chinese government will allow the renminbi to appreciate, considering that this would make its exports less competitive on the world market.
“The Chinese government is interested in maintaining a stable and slow appreciation of its currency,” says Kong.
China has reached a point where the marginal cost of labour is no longer competitive with the likes of Vietnam.
“Wages are now increasing and with the rise of its middle class, the economy will eventually move to a consumption-led market that will be dependent on export-led growth.”
Without reform of the welfare system, however, it appears unlikely the government will encourage consumption.
The Bank of International Settlements puts China’s aggregate marginal propensity to save at more than 50%. What differentiates China from the rest of the world is that it ranks near the top globally across all three components – government, corporates and households.
Its assessment of China’s economic prospects conclude that “policy measures promoting job creation and a stronger social safety net would contribute to the transition to a more balanced domestic demand”.
Kong acknowledges that the absence of a safety net is a “huge barrier” to China’s strategy to consumption, but points to ongoing reforms. The Chinese government says it plans to allocate more resources to pensions, healthcare and education as well as fighting rural poverty.
Wen’s successor, who will be appointed later this year, will not only face the challenges of rebalancing the economy but also distributing gains much more fairly.
©2012 funds global