Tuesday, March 8, 2011

Offshore Renminbi Bonds Here to Stay

The following article entitled “Asia credit investors scramble for offshore Renminbi bonds” appeared in Risk.Net and was authored by Chris Wright.

The expansion of the Hong Kong Renminbi bond market continues to gather pace, with recent firsts including an unrated deal, a debut from a Russian borrower and even a synthetic offering. Importantly, the transactions are even beginning to attract interest from buyers outside of Asia.

Rarely has a new market evolved so quickly as the offshore renminbi bond market. Even its nickname has been a swift affair: the term ‘dim sum bond’ only started appearing in October, competing with the somewhat dry predecessor ‘CNH bond’, and has since become ubiquitous. And less than a year after liberalisation measures that dramatically broadened the pool of potential issuers, the market has transformed in tenor, the credit curve, size and distribution.

“The development of the market has been phenomenal,” says Sean Henderson, head of debt syndicate, Asia-Pacific at HSBC.

One could argue the offshore RMB market has its roots in 2004, when the People’s Bank of China first allowed retail clients in Hong Kong to accumulate renminbi; or in 2007, when a handful of Chinese banks, chiefly policy institutions, were allowed to issue RMB bonds in Hong Kong to mop up the retail liquidity that had accrued in the meantime. But the landmark change came in February 2010 when the Hong Kong Monetary Authority, with China’s backing, said it would allow RMB bond business to be carried out in Hong Kong “in accordance with prevailing banking practices”. This, among other things, meant that anyone who was permitted to launch bonds in Hong Kong – that is, pretty much anyone – could do so in offshore RMB.

Numerous landmarks have since followed: Hopewell Highway Infrastructure, a RMB1.38 billion two-year deal in July, was the first corporate bond, while in the same month Citic Bank issued the first certificate of deposit deal. McDonald’s came to market with a RMB200 million deal in August, the first from a truly multinational corporate issuer; then October saw Asian Development Bank launch the first 10-year deal, a corporate bond from state-owned truck manufacturer Sinotruk and an issue from Export-Import Bank of Korea, which showed the willingness of Asian agency borrowers to tap the market. Deutsche and UBS have borrowed for themselves; and Caterpillar followed McDonald’s as another major US-based multinational keen to borrow in RMB.

Yet it was really at the end of last year that the sharpest illustration of maturity (or, if you take the opposite view, overheating) came, with several deals that all demonstrate different things about the market’s evolution.

Down the curve

Two came in consecutive days in December. First, Galaxy Entertainment Group raised RMB1.38 billion in a Regulation S deal on December 9. The following day, VTB Bank, the Russian financial institution, raised RMB1 billion through HSBC and VTB Capital. Both were three-year deals.

Galaxy, in particular, was an important trade. Although, strictly speaking, the issuer is unrated, the market considered it a high yield name. As such, it effectively represented the first appearance of high yield in the new market – and thus an expansion of investor appetite further down the curve.

“The Galaxy deal set a reference point for lower-rated credits,” says Paul Au, head of Asian debt syndication at UBS. “As a result, you will continue to see companies from different industries and with different credit standards accessing the market.”

“It probably came as a bit of a surprise to many people, because in any new debt capital market, high yield products usually take a longer time to develop,” says Tee Choon Hong, regional head of capital markets for North Asia at Standard Chartered. “Usually the more established credits form the market foundations before you see the emergence of high yield. But in the CNH bond market we have seen this develop quickly – in the same year.”

The other noteworthy point about the Galaxy issue was the price. Having been marketed around the 5% level, the bonds eventually came at 4.625%. Now, for investors who had become used to yields as low as 1% on deals from higher-rated borrowers like the Ministry of Finance (which launched a four-tranche deal at the end of November including a three-year tranche with a 1% coupon), 4.625% is a decent return. But in comparison to what an issuer like Galaxy would pay elsewhere, the return looks modest for the risk being taken. Galaxy does have an affiliate with a rating – Galaxy Casinos, which is rated B by S&P. Another B rated credit, Yuzhou Properties, went to the dollar high yield market the same week for roughly the same amount, yet paid 13.5%, albeit for a five-year, non-call three-year deal. That’s a mighty contrast, and Galaxy had plenty of demand, receiving RMB13.5 billion in orders with more than 80 institutional investors (mainly real-money) participating.

Similarly, the VTB issue offered further clues about pricing. It seems striking that a triple-B rated Russian bank with no presence in China, nor any stated intention to build one, can come to a market like this at all, but it did so at a cost of just 2.95%. Earlier in the year it had gone to the Singapore dollar markets and paid 4.2% for a shorter, two-year deal.

“One main reason the high yield market has progressed so swiftly is the yield differential,” says Tee. “When the Ministry of Finance is only paying 1% for a three-year bond, and bonds are then trading down substantially in terms of yield, there is a lot of attraction to a coupon of 4% or 5%. I think there is more to come.”

Underpinning price, though, is the fact investors are seeing the headline yield as only part of the investment case. Instead, they are also factoring in appreciation in the renminbi. “In the back of everyone’s mind is the potential currency appreciation,” says Henderson. “Some investors are starting with the dollar curve, then asking where the potential upside is in terms of appreciation before determining the levels at which they are prepared to purchase.”

Another deal that marked a significant step came via Shui On Land, which raised RMB3 billion in December. The deal would have been noteworthy for the level of investor appetite alone – the order book hit RMB32 billion, 21 times oversubscription for what had originally been pitched as a RMB1.5–2 billion deal, in just seven hours of book-building. But of even greater relevance, the issue was the first synthetic transaction in the dim sum market, with settlement in US dollars.

From an investor perspective, the 6.875% yield looked very attractive for this market (though probably about 2% less than the borrower would have to pay for a vanilla dollar bond); but in addition, investors get to enjoy any appreciation in the value of the RMB. Additionally, with settlement in dollars, they don’t necessarily need to have a use for the Chinese currency, nor navigate the swap markets. Consequently, the previously Hong Kong-dominated market for these deals was broadened to a global audience.

Deutsche, Standard Chartered and UBS, who led the deal, had planned to launch it early in 2011 but brought it forward after seeing the momentum demonstrated by Galaxy. Although the bulk of demand came from Asia – particularly private banks – the buying constituency is thought to have been far broader. “Those sitting on a lot of CNH are not the sort of private investors who bought this,” says Tee, one of the bookrunners on the deal. “By and large, it was bought by holders of US dollar accounts who don’t mind participating in the appreciation of the RMB.”

Going down the synthetic route addresses one of the natural bottlenecks to further development of this sector: the swap market. This is a new market, expensive and somewhat illiquid. Shui On, for example, might have had to pay a further 3% through the swap market had it raised funds in RMB and switched them into Hong Kong or US dollars.

It is already clear the synthetic route will be an attractive option for many borrowers. Within a week of the start of the year, Fujian-based residential property group China SCE Property Holdings had raised RMB2 billion, once again with US dollar settlement. But this trade, led by Deutsche and HSBC, took a Regulation S/Rule 144a format, allowing US investors to participate in the market for the first time. This deal had to pay a much higher yield than others in the market – 10.5% – partly reflecting its longer five-year tenor. Yet once again, relative to the cost of funding in dollars, it was almost certainly several percentage points cheaper. It is understood European accounts took 12% of the bonds and US investors 10%.

“Single-B rated Chinese property sector names have seen quite heavy supply in US dollar,” says Henderson. “However, we still saw some very good interest out of the US in their dim sum offerings from some high quality investors. That bodes well for other borrowers looking at CNH with 144A docs. I think we will see a broadening of interest going forward.”

One other deal is worthy of further examination. On December 1, Export-Import Bank of China, known as Chexim, priced a dual-tranche RMB5 billion bond. The headlines on this talked mainly about oversubscription – its RMB1 billion institutional tranche was covered 53 times over, thought to be a record – but in fact the more interesting trend may have been buried a little deeper. Although 88% of the institutional deal went into Asian accounts, chiefly in Hong Kong, some 12% of the bonds placed in Europe.

This is a striking development, because it shows that even in non-synthetic deals there is an order book available outside Asia if one goes looking for it (and generally bookrunners haven’t had to so far, such has been the demand within Asia). “Increasingly in Europe very large fund managers are seeing appetite among their clients to get access to this story,” says a banker who worked on the deal. “It’s going to develop quite quickly: there are plenty of people active now who didn’t even have accounts a month ago, let alone six months ago.”

Au at UBS notes a similar trend. “At the moment, not every account is set up or mandated to buy RMB products, whereas Asian accounts are at the advanced stage of internal approvals,” he says. “But over time, once people are more familiar with the product, you will see more participation outside Asia from the current 10%–15% in a Reg S-only transaction.”

Tee, while noting an increase in non-Hong Kong investors, particularly in Singapore, says that non-Asian investors are still very much a minority. “Although the market has developed significantly, new issue volume is still small. For some of the larger accounts, there is always a consideration of efficiency; the size of the deal, how much they can put their hands on given that most of the deals have been heavily oversubscribed and the allocations are usually quite small. That makes it less attractive to some of the larger offshore accounts.”

But he adds: “Based on the seminars we have held, both regionally and in US and Europe, the interest is immense. It’s only a matter of time.”

And the diversification of the investor base is not just geographical. “Retail deposits in RMB have obviously continued to grow in the last year or two, but the majority of the recent growth has been from the fund management side,” says Henderson. “There are a number of new entrants looking to buy RMB assets in order to create a product offering in the currency for their clients. This new investor base means instead of just having 20 or 40 investors, we’re now seeing much more diverse order books, which has in turn broadened the list of potential issuers across the full credit spectrum.”

A growing appetite

Underpinning the whole market is a supply/demand imbalance that seems to become more stark with every deal. When the Ministry of Finance set out to raise RMB5 billion via an institutional tranche in December, it attracted a RMB50 billion book. Data from the Hong Kong Monetary Authority shows that at the end of November, renminbi deposits stood at RMB279.6 billion – up from RMB217 billion the previous month, RMB150 billion the month before that and barely RMB70 billion in the first quarter of 2009. That’s a truly extraordinary rate of growth. The money needs somewhere to go and that, fundamentally, is what is driving tight pricing.

“The pool of RMB is still far from what you would call significant in the grand scheme of things: it’s about 3% of total bank deposits in Hong Kong,” says Tee. “But it has quadrupled within less than a year. It is enough to allow the formation of basic debt capital markets to recycle the money, and there currently isn’t any other viable instrument in town.”

In addition to retail buyers wanting a decent return on their money, the Hong Kong banks that hold those deposits create an institutional market with an equally ardent thirst for some decent yield; particularly since, with the funds being held among so few banks, there’s not much of an interbank market and no equivalent of Libor through which to pass on liquidity.

The only things that can change this imbalance are, logically, a vast increase in supply (which is where the opportunistic financings in December came in); a tapering off of demand (unlikely, since there’s no reason for the growth of deposits to halt); or an increasing range of alternatives for that money to be invested in.

“There are rumours about potential equity products that could be done in CNH, but the bond market has moved quite far ahead and will continue to see interest,” says Tee. “At the end of the day the free market will find its own balance.” But he notes that the many eccentricities on the supply and demand side – bank liquidity reserves, the lack of an interbank market, likely interest rate movements in China and Hong Kong – make it hard to draw conclusions from the way other markets have evolved.

“I like to compare the differences between the CNH bond market and the domestic bond market with the differences we have seen in stock markets between H shares and A shares,” he says. “It is two different patterns of price behaviour.”

Still, some feel that the balance is already on its way. “You will see an equilibrium over time between supply and demand,” says Au. “At the moment it’s all about product with a little less focus on price, but once we get more supply you will start to see people differentiate between credits and assign different valuations to them. As the market grows over time, the pricing reference points will fall into place naturally. We just need more deals.”

Yuan some, you lose some

It is evident the market faces some headwinds. One is repatriation of capital to the mainland. For those businesses raising funds in renminbi because they actually need the currency, moving the funds from Hong Kong to where they are needed has not always proved straightforward. This was most clearly in evidence with the McDonald’s bond, where repatriation issues took weeks to resolve and took the shine off what had otherwise been seen as a landmark success. “If you don’t have a use for the funds or approval to remit them, the swap back to other currencies can be quite painful,” says one banker.

That raises another problem. For borrowers who do not want the renminbi, they need to swap it out, and there is not much liquidity in this fledgling market. At best, it is going to cost 2–3% of the proceeds, which in some cases can wipe out the funding advantage versus dollars. Sources say there is liquidity for swaps at one year, but not far beyond. Until there is a natural flow of business to drive it, that will not change.

“The general expectation is that the currency is going to go up, so it is going to be harder to develop a deep enough market for a counterparty to take the other side of the swap – that is, for the RMB to depreciate,” says Au. “The market has to grow further – not just the bond market but trade finance and other forms of liabilities – in order for it to become deep enough for sizable [swap] transactions.”

Although it doesn’t matter so much, it is also notable there is barely a secondary market in these bonds. Their scarcity value means few who buy them have any interest in selling them on. “Our challenge is being unable to get the allocation in the secondary market,” says one banker. “Almost nobody is selling. The minute anyone comes out with a small clip, it’s snapped up.”

For the future, there are some developments we should expect to bed in as with any new market: more deals at longer tenors, to accompany the Ministry of Finance and Asian Development Bank’s 10-year deals; further development of the credit curve, with more high yield deals like Galaxy; and eventually the development of a secondary market. No doubt, like everything else in this improbably vibrant sector, change will happen fast.