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An Analysis of Investment Value of Dim Sum Bonds and Chinese US Dollar Bonds

Published time:[24 May, 2016 18:19] From:E Fund Management (HK) Co., Limited

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An Analysis of Investment Value of Dim Sum Bonds and Chinese US Dollar Bonds

24 May 2016

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Highlights


In the backdrop of China’s stock market crash, prevailing macroeconomic weakness and a lax monetary policy by the PBoC in 2015, the Chinese onshore bond market has experienced the longest bull run in history of more than 2 years. Ten-year China government bond yield fell drastically from 3.63% at the end of 2014 to 2.82% a year later. In contrast, offshore bond yields remain higher than the onshore bonds despite having been driven down by the latter. The PBoC auctioned one-year bills (Dim Sum bonds) aggregating RMB 5 billion at an average yield of 3.1% in London last October. This issue was oversubscribed five times and the yield-to-maturity was 40 basis points higher than onshore government bonds with the same maturity. Lower yields of domestic bonds have been resulting in narrowing of credit spreads and smaller carrying costs, giving rise to the expectation that the demand for offshore bonds with higher yields will continue to rise.

Value Analysis of Dim Sum Bonds

Dim Sum bonds generally refer to offshore RMB bonds issued in Hong Kong. The market began to develop as early as in 2007 but Chinese financial institutions and sovereign entities were the only issuers, which limited the scale of the said market. The market had not changed dramatically until 2010 when the RMB started appreciating. Later restraints on issuers were gradually relaxed to allow companies worldwide to issue RMB-nominated bonds in Hong Kong, which triggered rapid growth of the Dim Sum bond market. Dim Sum bond yields used to be lower than onshore bonds of the same category since the appreciation of yuan was still in its early stages and the types of bonds available for investment were also relatively limited. The trend in yield-to-maturity of the 10-year government bonds shows that yields on onshore bonds have always been higher than offshore bonds until 2015. However, after China launched the Exchange Rate Regime Reform on August 11 2015, expectations of RMB devaluation and concerns about liquidity in the offshore market drove Dim Sum bond yields up, widening the spread between onshore and offshore bonds of the same category. As a result, Dim Sum bonds have recaptured the attention of investors in the light of the higher yields.
Source:Bloomberg, Data as of 3/5/2016
Source:Bloomberg, Wind, Data as of 3/5/2016
Value Analysis of China US Dollar Bonds

On the contrary, the market for USD-denominated bonds in Asia has been around for a considerably longer period of time and, consequently, is a relatively more mature market. Compared to the Dim Sum bond market, the Asian US dollar bond market is more diverse in terms of size, maturity distribution and credit ratings while having higher liquidity. More than half of the US Dollar bonds issued in Hong Kong are issued by Chinese entities. Generally speaking, given the same rating and maturity, bonds issued in US dollars by Chinese entities have had higher yields compared to other Asian US dollar bonds, which presents an attractive investment opportunity for investors familiar with Chinese enterprises. At the same time, global economic growth has slowed down since the second half of the last year. Yields of government bonds of some economies have reached new lows with Japan announcing the introduction of negative interest rates earlier this year. In contrast, although China's economic growth has stalled, it continues to outperform several major economies by a wide margin and the majority of investors remain optimistic about its long-term investment value. RMB is currently going through a weak phase, the relatively stable Chinese US dollar bonds hold additional value to investors.
Source:Bloomberg, Data as of 3/5/2016
Source:Bloomberg, Wind, Data as of 3/5/2016
Relative Value Analysis

Unlike Dim Sum bonds, yields of Chinese US dollar bonds are not significantly higher than onshore bonds of the same category. However, high-yield US dollar bonds remain appealing to investors at large.  When US dollar bonds are hedged against variations in foreign exchange rates, yields-to-maturity in RMB is more attractive, based on the principle that interest parity implies absence of arbitrage opportunities. A risk-free RMB income portfolio consisting of US dollar bonds can be achieved by holding end positions in US dollar bonds together with exchange rate derivatives of same maturities to hedge against foreign exchange risk. Currently available foreign exchange derivatives can be roughly classified into three types, namely, currency swaps, foreign exchange futures and forward foreign exchange, all of which carry similar implied hedging costs. Backwardation of RMB forward rates implies that US dollar bonds carry an additional 2.31% return by locking foreign exchange rates.
Source:Bloomberg, Data as of 3/5/2016
When comparing the value of Chinese issued Dim Sum bonds with remaining maturity of one year to comparable US dollar bonds, the yield of the latter and the respective backwardation of foreign exchange forward rates need to be added for calculating the equivalent rate of return in RMB. As indicated in the chart below, investment-grade US dollar-denominated bonds broadly offer RMB yields similar to Dim Sum bonds on average, while high-yield bonds can offer return higher than even Dim Sum bonds. In addition, a RMB portfolio consisting of foreign exchange derivatives has two advantages. First, the size and liquidity of the US dollar bond market dwarf that of Dim Sum bonds, which implies drastically greater depth of the market. Moreover, since the remaining maturities of Dim Sum bonds are generally shorter and primary issuance is limited, US dollar bonds are often issued with maturities that are determined on the basis of demand in the market. In general, a RMB portfolio consisting of US dollar bonds and foreign exchange derivatives should generate higher investment value for Dim Sum bond investors.
Source:Bloomberg, Data as of 3/5/2016
Source:Bloomberg, Wind, Data as of 3/5/2016
Jeffery Qi, Portfolio Manager
Fixed Income Team, E Fund Management (HK) Co. Limited

 
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