ICBC

A long-awaited deal from ICBC successfully cleared the market late on Wednesday, enticing investors with the first true exposure to a mainland Chinese bank in an international bond market.

The US$750 million 10-year senior unsecured bond, issued by a vehicle called Skysea International Capital Management, was guaranteed by ICBC’s Hong Kong branch. This is a crucial distinction: Hong Kong is a full branch and represents exposure to the parent, whereas all other deals from mainland Chinese banks in the dollar markets have been through subsidiaries such as ICBC Asia or Bank of China (Hong Kong), giving exposure instead to Hong Kong subsidiaries. “This transaction provides the market with the very first direct exposure to the Chinese banking space,” said someone close to the deal. “All the other names are quasi, pseudo Chinese banks.”

Perhaps for this reason, the deal was marked by far higher than usual participation from Asian insurance companies. 95% of the deal went to Asia – Europe and the US represent no happy hunting ground at the moment – with insurers representing 33% of the book. “It’s not common at all to allocate one third into insurance,” said one banker. “They are buy and hold, high quality accounts, so we wanted to give as much bonds to them as we could, and we managed to find quite a number of anchors from insurance companies.”  Banks took 29%, fund managers 25%, private banks 8%, and corporates and others 5%. “It’s a unique opportunity for insurers to get direct exposure to the Chinese banking sector, and there are not many 10 year issues – insurance funds prefer that longer duration to match their liabilities,” the banker said.

For some weeks, market talk has been about ICBC’s willingness, or otherwise, to accept the price necessary to issue in such a challenging market. In the event they came at 310 basis points over Treasuries, inside guidance of 320, and proved popular, with an orderbook of over $2.25 billion from 160 accounts. “The issuer clearly has been very price conscious,” said one banker close to the deal. “They did the roadshow back in October and they have been monitoring the markets. It’s been very volatile.”

UBS, Barclays and ICBC International were joint global coordinators, alongside HSBC and Standard Chartered as joint bookrunners, on the Regulation S deal, which carried a 4.875% coupon with a re-offer price of 97.708%.

This week has looked brighter for debt markets after a miserable and volatile spell, although it remains to be seen how long it lasts. “I think the window has been open since the start of the week,” one banker said. The global joint intervention by central bankers is felt to have had a bigger impact on equity markets than debt markets, but “in the credit market we do feel better as well,” a banker said. ICBC moved in about 10 basis points on Thursday morning from launch, in line with the broader market.

An illustration of the improved conditions was a deal in the market as Euroweek went to press for Hyundai Motor Company, through its Hyundai Capital America vehicle. This 5.5 year 144a/Regulation S deal was capped at $500 million, and expected to raise that amount, in a deal through Bank of America Merrill Lynch, BNP, HSBC, JP Morgan and Morgan Stanley. It was being offered at guidance of 345 basis points over five-year treasuries as of Thursday afternoon, Asia time. The 5.5-year tenor is becoming more commonplace in Asia; KDB launched a $1 billion deal of that duration in October, and a subsequent bond from Bank of East Asia was 10.5 years with a call at 5.5.

Other deals expected from the market do not appear ready to launch. Reliance Industries has appointed Bank of America Merrill Lynch, Citigroup and UBS as lead managers on an expected US$1 billion 10-year; someone close to the issuer said they were “still watching and waiting” last night. And Chinese internet company tencent has completed a worldwide roadshow, concluding in New York, for a Reg S/144a dollar deal of its own through Deutsche, Goldman Sachs, Credit Suisse and HSBC, but yesterday the leads were “continuing to monitor the market”.

DIM SUM

The dim sum bond market continues to break new ground after last week’s landmark Chinese corporate issue from Baosteel. This week brought a new issuer and the first mandate to Latin America, even as the CNH deposit base in Hong Kong declined.

The new issuer was BMW Australia Finance, whose RMB400 million one-year deal was the second from an Australian corporate after Fonterra, which launched a RMB300 million three-year deal in June.

The deal paid a coupon of 2.4% and was re-offered at 2.4%. BNP Paribas was sole bookrunner on the deal.

Further ahead, the Mexican telecommunications group America Movil will hit the road next week for a dim sum bond of its own – the first from Latin America. It is understood the company, owned by Carlos Slim, will meet investors in Singapore on Monday and in Hong Kong on Tuesday, with HSBC as sole arranger.

While demand for these securities has generally outweighed supply in the market’s brief history, in October the CNH base – RMB deposits in Hong Kong – declined modestly. Deposits stood at RMB618.5 billion, down 0.6% from RMB622 billion in September, in a reversal of the often exponential growth in deposits over the last two years that has frequently hit 10% per month. That said, analysts had expected worse, with HSBC calling the decline “not as much as we originally expected” and saying “the fact that CNH deposits and trade settlement activity only declined modestly gives some comfort about the overall resilience of the offshore RMB system, as a vehicle for RMB internationalization.”

The deals follow last week’s RMB3.6 billion dim sum bond from Chinese state-owned steelmaker Baosteel, the largest corporate dim sum bond to date and a clear illustration that no matter how bad the global macro picture may become, there is stout appetite for the right Chinese names in RMB. That deal included three tranches from two to five years, all of them oversubscribed and all at the tight end of guidance. It attracted a total book of almost RMB9 billion from 200 orders.

Baosteel was the first example of a group that are expected to be regular issuers: PRC state-owned companies issuing in their own legal form rather than through an offshore company or vehicle.

GLP

Singapore’s Global Logistics Properties, a company backed by the GIC sovereign wealth fund, launched a S$500 million perpetual hybrid on Wednesday in a deal marketed carefully around its name appeal to Singaporeans.

The deal, which priced at a 5.5% yield, went mainly to Singaporeans – who took 92% of the paper – and within that, mainly private banks, who accounted for 78% of the deal, well ahead of fund managers and banks with 10% apiece. The coupon equates to 420 basis points over five-year swaps.

GLP is considered an exceptionally strong name in Singapore because of its GIC links; its 2010 IPO in Singapore was one of the biggest ever in the city state, despite the fact that its holdings are all industrial and logistical properties in China and Japan with little connection to Singapore. Those close to the deal claim the pricing was as much as 3% lower than would have been achieved in the dollar bond markets, if a deal could have been done at all. “If you look at an investment grade name like China Resources Power as a guide, then [for GLP in dollars] it would be very high single digits now, 8% plus,” says one banker. “In fact this deal couldn’t have been done in dollars at all a couple of weeks ago, or before this week’s central bank liquidity measures.”

From the local investor perspective, perpetuals offer much better yield than many fixed income alternatives in a low interest environment – Cheung Kong was another recent example of a Singapore dollar perpetual issuer. JP Morgan was sole global coordinator, with Citi, Goldman Sachs and DBS joining it as joint bookrunners.

“An insight gained from Cheung Kong was that it was clear private banks were going to be a dominant part of the distribution,” said someone close to the deal. “In this deal, we enhanced the appeal to the institutional investor base, which played a greater role in this than in Cheung Kong.” It was challenging to find a suitable comparable to price from; one approach was to calculate what the borrower would pay for senior debt in Singapore dollars, and then add suitable yield for the paper’s subordination. “Investors were looking for direction from us on pricing,” said one banker. “But Singapore accounts are very happy with 5%-plus yield and a good investment profile. They have money in the bank earning zero: if they want to earn 5%, they can take a flyer on a risky name, or buy subordinated paper from a name they are comfortable with.”

The deal cannot be called in the first five years but is very likely to be redeemed thereafter, as the bonds lose their 50% equity treatment from April 2017, at which point they will no longer be helping the issuer to reduce their debt to equity ratios.  After 10 years there is a 100 basis point step up, but the bonds are highly unlikely to be outstanding beyond that date.

KOREAN AIR

Korean Air closed a US$300 million asset-backed deal this week to enliven what has been a quiet period for securitizations from Asia.

Standard Chartered was lead manager and sole arranger on the issue of secured floating rate notes, the first dollar securitization of passenger ticket sales by the airline. Most of the receivables are from KAL’s North America routes. KDB was credit facility provider and swap provider on the deal, a move that clearly helped in this volatile environment, giving investors comfort that they were effectively taking KDB risk.

The transaction matures in October 2014 and offers a floating rate coupon of one month dollar libor plus 200 basis points. Standard Chartered’s global head of structured financing solutions, Warren Lee, called it “very competitive pricing despite the continuing market turmoil.” The receivables have a weighted average life of 1.5 years, and the notes were rated A1(sf) by Moody’s. The notes are listed on the Irish Stock Exchange.

KAL is a reasonably familiar name in the asset-backed markets despite never having issued in dollars before; the transaction is its sixth cross-border ABS deal, and follows five previous deals in yen. Moon Kwon Oh, general manager and head of the financing team at KAL, said it was “meaningful for the company that this transaction is backed by USD denominated assets for the first time.” The deal is understood to have had considerable overlap with the investor base of KDB’s own $1 billion 5.5-year global bond in October.

Observers found two points of significance in the deal. One was that a dollar securitization was taking place at all in such difficult markets, although it was not clear that there was a pipeline of similar deals looking to follow. The other was curiosity about the approach of KDB, whose role as credit facility provider on this deal follows a guarantee on a $350 million bond for Doosan Heavy Infrastructure last week. It will be interesting to see if KDB offers further guarantees and facilities as a means of raising additional fee revenue in the months ahead.

DIM SUM

Issues from Orix, Baosteel and Shougang Corp this week showed that there is still appetite for dim sum bonds, even as world capital markets turn increasingly nasty.

Yesterday Baosteel, the Chinese state-owned steelmaker, raised xxx in a three-tranche issue lead managed by Deutsche Bank and HSBC as joint global coordinators and bookrunners, with China Merchants Securities, DBS, ICBC and Standard Chartered as joint bookrunners.

The deal was significant because it was the first mainland company to issue an offshore RMB bond. Numerous mainland entities have issued offshore, but until now always through an offshore vehicle. A recent change of regulation permitted onshore borrowers to raise funds in this way, and bankers expect to see many more issues from mainland enterprises in this market.

Its success was hearting to investors, with a total book size of xxx. “It was enormously well received,” said someone close to the deal. “There was standing room only at the roadshow lunch in Singapore, 130-odd people in Hong Kong. Baosteel is huge, one of the pre-eminent producers in China, and being owned by SASAC it’s seen as a strategic company.”

The deal was made of three benchmarks. A two-year deal was offered at a range of 3.125% to 3.375%, and priced at x; a three-year bond came with guidance of 3.5% to 3.75% and priced at x; and a five-year tranche was offered at 4.375%-4.625%. Yesterday morning there was talk of a deal as big as RMB6.5 billion, since the company had been given approval to raise up to that amount, but those close to the deal said a more realistic target had been about RMB4 billion.

The bonds, expected to be rated A3/A/A- by Moody’s, S&P and Fitch in line with the borrower rating, carry a change of control clause with a put at 101% if state ownership (through SASAC) falls to 50% or below.

Also yesterday, another steelmaker, Shougang Corp, priced an offshore Reg S reniminbi bond in Hong Kong, raising RMB1 billion in a two-year transaction. This deal priced at 4.875%, in line with guidance, and was lead managed by Bank of China International, Citic Bank International, DBS, ICBC Asia, JP Morgan and Wing Lung Bank. The deal was unrated.

The Baosteel deal followed a RMB500 million three-year issue from Japanese Orix Corp earlier in the week. This was Orix’s second issue in the market, and being a repeat issuer clearly helped the deal get away smoothly, but attracted inevitable comparisons with its outstanding paper: Orix priced at 4%, while outstanding bonds due March 2014 were paying 3.35% – having been launched at just 2%. Joint bookrunners on this deal were ANZ, BNP Paribas, Credit Agricole, Daiwa, Mizuho and Standard Chartered. “Orix were cognisant of the new issue premium payable and it was not a problematic trade of any sort,” said one person close to the deal. “A well known name, repeat issuer; a nice easy one to get away.”

52% of the paper went to Hong Kong, 39% to China/Taiwan and 9% to Singapore. Insurers were the largest group by investor type, taking 49%, followed by private banks (24%), funds (19%) and banks (8%).

HYBRIDS

Australia’s regulator yesterday warned consumers about dangers in hybrid securities, in a move that seemed timed to coincide with the delay of a hybrid issue from Origin Energy.

On Tuesday, Origin began a bookbuild process for a A$500 million hybrid notes issue through ANZ, Commonwealth Bank of Australia, National Australia Bank, Macquarie Bank and UBS. The offer was due to open for retail investors the following day, but instead Origin announced that ASIC had extended the exposure period for the prospectus by seven days – that is, increased the length of time for study of the prospectus before the formal opening of the deal. Origin said: “The extension will allow ASIC to consider further the terms in the prospectus, including aspects relating to the mandatory deferral of interest payments.”Origin said it had received “very strong investor demand” for the notes, and said it and its advisors were “in discussions with ASIC with a view to resolving this matter as soon as practicable.”

Then, just before 6pm Sydney time, yesterday, ASIC put out a statement asking consumers to make sure they understand the conditions and risks of hybrid securities and unsecured notes before investing. “With considerable volatility in equity markets, many investors are looking for alternative investments, including debt and fixed interest securities,” said ASIC. “However, some of these alternatives need close scrutiny before the decision to invest is made.”

The announcement quoted ASIC chairman Greg Medcraft as saying: “In some cases investors are taking on equity-like risks but only receiving bond-like returns. Investors need to understand the conditions of these offers, such as terms and conditions that allow the issuer to exit the deal or suspend interest payments, and long term maturity dates of several decades.” The Origin notes have a 60-year maturity but are callable from 2016, with a 100 basis point step up if they have not been redeemed after 25 years.

Approach by Euroweek, an ASIC spokesman said: “We have no comment about the Origin deal specifically.” But market participants said it was telling that the ASIC warning specifically highlighted deferral of interest payments – saying it “could leave investors temporarily out of pocket” and “the security’s market price may also be damaged by the decision to hold back interest payments” – when that was also explicitly stated as the reason the Origin issue was delayed by the regulator for further study.

ASIC also warned about market price volatility, the subordinated ranking of hybrid securities, early termination rates that apply to the issuer but not the investor, and the increased risk of extremely long timeframes.

The Origin deal was originally intended to close on December 12 for the shareholder and general offers and December 19 for the broker firm offer, with issuance on December 20.

DOLLAR DEALS

The market is watching two Asian issuers to see if they are prepared to brave the treacherous dollar markets next week. Chinese internet company tencent has completed a roadshow in the US, while Reliance Industries is pondering a benchmark deal of its own.

Of the two, tencent is closest to issuing. A roadshow that began in November 15 in Hong Kong before moving to Singapore and London concluded in the US on Wednesday ahead of the Thanksgiving holidays. If market conditions oblige, a Reg S/144a dollar deal should follow next week, although it appears a crushingly difficult market in which to raise a debut bond from a Baa1/BBB+ rated internet services provider with no obvious comparable to price against. Goldman Sachs and Deutsche bank are joint global co-ordinators on the sale, alongside Credit Suisse and HSBC as joint lead managers and bookrunners; those close to the deal describe the mood around the roadshow as “positive”.

Reliance Industries is somewhat further away. Market talk is of a two tranche deal with 10 and 30 year tranches in dollars, but at the time of writing the issuer had still not confirmed the lead managers, nor given the green light to a deal going ahead at all. Mandates were proving characteristically competitive. As one banker put it: “We are standing very close to it, and shouting that we should be on it, and others are doing the same, while the company is playing one off against the other. There are more players being told the deal is theirs to lose than there are seats at the table.”

Another spoke of the issuer “getting commitments from bookrunners on terms that aren’t exactly commercial.” And yesterday afternoon one banker said “it looks like it’s not going anytime soon.”

Bank of China (Hong Kong) continued the flood of new issuance from Asian borrowers in dollars with a US$750 million issue of five-year senior notes last night. But a widening of the deal in the secondary market reflecting a toughening of market conditions in light of uncertain news from Greece. The sense is that the issuer may have been lucky to get a deal out in a window that has now closed.

The bond, led by BOC International, Citigroup and Deutsche Bank as joint bookrunners, tightened from price guidance of around 290 basis points over Treasuries to price at 280 during the US working day on Monday. But in early Asian trading the bond approached 300 basis points – one banker says it was briefly bid as wide as 302 – before settling around a 293 bid by lunchtime, 13 basis points wide of its price at issue.

Those close to the deal feel that the widening of the bond was in line with the broader market, and that the shock announcement yesterday that Greece will seek a referendum on the European rescue package had caused the widening. Relevant benchmarks behaved similarly, as did recent new issues, with KDB – which issued a US$1 billion benchmark last week – having moved from a 272 bid to 295 in a day, and being 14 points wider than its previous close at the time when BOCHK had widened 13. But others in the market grumbled at a deal they feel may have derailed the positive investment sentiment of the last two weeks that had allowed a number of benchmark deals to get away. “Trading 20 basis points wider by the morning is a shock with a new issue,” said one banker. “Yes the market was weaker overnight. But it printed late: it was pretty clear by then the market was heading south and there are ways for banks to defend an issue. It doesn’t help the capital markets to see such execution.”

One very striking element of the deal was its distribution: despite being a Rule 144a/Regulation S combination, 80% of the book went to Asia and just 4% to the USA, with the remaining 16% selling to Europe. (By investor type, the book was more typical, with 37% fund managers, 39% banks, 8% insurance and 16% private banks.)

The distribution clearly reflected the changing macroeconomic mood as the deal was sold. During the early Asian day, conditions appeared reasonably positive, before a more bearish tone caused the European market to open 2% down and the US 1.5% down. “4% going to the US was lower than we would have hoped for, but we had the referendum announcement in Greece,” said someone close to the deal. “Macro dynamics played a big part in the distribution of this deal.” The announcement of another Regulation S deal by ICBC also hit demand; Nomura’s trading desk, for example, was understood to be advising institutional investors to avoid the Bank of China deal in favour of ICBC.

While the deal attracted a $2 billion book, the issuer did not increase the size of the deal, perhaps mindful that it had probably already been lucky generating heavy demand from Asia just before the issuance window closed. “With $2 billion they could have looked for bigger, but they wanted to size it in the context of the macro backdrop we were in,” says one banker.

Where asset markets grow, mutual funds follow. As the CNH, or dim sum, bond market develops around offshore issues in RMB, an increasingly well-diversified asset management industry is taking shape alongside it.

Hard data is difficult to come by, but Asiamoney is aware of almost 30 separate mutual funds or similar investment structures investing mainly in offshore RMB bonds. Already, there is a market with several clearly defined strategies: some focus on credit, others high grade, while some combine bond exposure with deposits and futures, and still others bolster their portfolios with Asian dollar high yield deals which they swap back into RMB.

At one end of the market are the big international names one would expect to see in any new debt market: HSBC, Schroders, UBS, Barclays. Alongside them are a host of home-grown Hong Kong or Chinese names: Haitong, Hang Seng, Citic, Ping An. Some are on their second or third funds. HSBC already has a US$500 million Cayman-domiciled fund, the HSBC RMB Bond Fund, and has just launched a UCITS-compliant fund domiciled in Luxembourg to broaden the reach to a wider audience, particularly clients in Europe. It is launching an RMB currency fund in North America and will look at other structures too. “It’s fair to say that Hong Kong is the home of the offshore RMB, and the home market of HSBC,” says Geoffrey Lunt, director and senior product specialist for fixed income at HSBC Global Asset Management. “For other fund managers this may be a peripheral activity; for us it’s at the very centre of what we do.”

Any discussion about offshore RMB quickly reaches the subject of the supply and demand imbalance: RMB deposits in Hong Kong reached RMB609 billion at the end of August and have at times routinely grown by 10% per month. The need for these assets to be invested in more yield-producing assets has created an imbalance that has, in the past, allowed some very average credit to raise money at very low rates. But every fund manager spoken to by Asiamoney described a relatively easy time allocating the funds they raise, and getting access to the bonds they want.

“We have not had significant trouble investing that money,” says Lunt of HSBC’s $500 million fund. “We are very happy with the way the market has developed and we’ve been able to cope with a lot of the demand we’ve seen for the product.”

Chris Faddy, Head of Distribution at Barclays Capital Fund Solutions for ex-Japan Asia, says fund managers on Barclays’ Renminbi Bond Fund – launched in Singapore in April – have had no problem getting the securities they prefer. “We are extremely aware of the discussion around liquidity,” he says. “However, our experience has been that we have got a full or 80% allocation of every single primary issue we have participated in. The key to participation is relationships: either the fund managers like ourselves that are part of an investment bank, or those with strong relationships with the key brokers, will get the better access.”

Similarly at Singapore’s Fullerton Asset Management, Patrick Yeo says Fullerton’s offshore RMB fund – with US$245 million under management – “could easily go up to $400 or $500 million” without running into problems with allocation. Again, it’s about relationships, he says. “One of our strengths is that we have pretty good relationships with our counterparts,” he says. “Temasek [which owns Fullerton] is an investor in a lot of the Chinese banks such as Bank of China, which is one of the major players in the CNH market, so if they bring in deals and we participate, we tend to get very good allocation.”

And the many local Chinese players report a similar experience. Ben Rudd is executive director and head of overseas investment at Ping An Asset Management (HK), which has seen its RMB fund climb from RMB205 million at inception to RMB1.55 billion, with precisely one day of net redemptions along the way. “Although competition is quite intense in the new issuance market, based on existing relationships with both Chinese and international banks and our strong brand and team, we are normally able to get a high allocation for our issues in primary deals of 80 to 100% of the desired size,” he says in written responses to questions from Asiamoney.

Getting in at the primary market level is crucial, because demand is pushing the secondary markets to much less appealing levels, where there is liquidity at all. “We can’t be buying on the secondary market all the time – that would reduce yield,” says Faddy at Barclays. “The difference between primary and secondary on an issue could be over 1, 1.5%. We picked up Air Liquide on the primary market; those types of securities are trading 100 points under on the secondary market.” That said, secondary market activity is improving; where average ticket size in secondary trading was around $3-5 million at the end of 2010, it is now more like $10-30 million, Rudd says, and in some cases as high as $75 million, a function of increased issuance and the appearance of new trading desks. “Clearly liquidity has surged dramatically for the last nine months,” he says.

There are three reasons concerns about allocation and liquidity have eased. One is that many funds have been smart about the amount of assets they are prepared to accept. “At no stage did we want to compromise our clients by promising too much capacity to them,” says Lunt. “We have been very careful about the growth of our funds in this area.” Faddy makes the same point: “We have been very deliberate in building our asset base slowly. To actively participate in the primary market we need to make sure we don’t grow our assets too quickly.”

Another reason is that the market has now reached a decent size: just over RMB200 billion at the time of writing. It has become reasonably diversified by industry, credit quality and geography – though not yet really by maturity – and this has made life easier for managers trying to pursue a particular strategy rather than just having to buy assets in order to get something. “It has not been too difficult to diversify the portfolio,” says Rudd. With size has come a certain resilience; Lunt notes how encouraging it was to see two-way pricing maintained in the market throughout the recent global volatility. And there’s little reason to expect supply to fade. “In the last few weeks of market disruptions, this [offshore RMB] was one of the few that was effectively still open,” says Suanjin Tan, portfolio manager at Blackrock, which invests in offshore RMB for its regional products and plans to launch a dedicated RMB fund. “We’re quite comfortable with the supply pipeline in this market. The expectation is for RMB30-40 billion in the last quarter of the year: there are lots of Chinese banks, Chinese quasi-sovereigns and multinationals planning to issue.” Others think the figure could be higher.

But the third, and perhaps the most important, is that investor attitudes towards offshore RMB have changed. Where once investors appeared to be prepared to buy anything regardless of cost, quality or investor protection, times have changed, and clearly for the better.

“Initially the market was characterized by some poor quality issuance, given the excess of demand over supply,” says Lunt. “I don’t necessarily mean that the companies were bad, just that the covenants on the bonds were not tight and the yields were far too low, with disclosure below what you would hope for in developed markets.”

Investor patterns have been of particular interest to BlackRock as they prepare their fund. “Most participants looked to the market just for FX appreciation until recently,” says Tan. “There was not a lot of differentiation on the credit quality of companies in the market. But with volatility investors have started to realise that one credit is not necessarily the same as another, and have tried to work out what is the correct premium for that level of risk. That is a very healthy development.”

Changed expectations about currency appreciation are one reason for this shift, but there’s also perhaps a realisation among issuers that they need to pay more for their money in a difficult global environment. “Fund managers like ourselves are more cautious, worrying that if investors get jittery about this market they might pull funds out,” says Yeo at Fullerton. “We are adopting a wait and see attitude. But things have settled down: it’s a matter of issuers coming to terms with having to offer a higher yield to the market.” When Khazanah priced a RMB500 million deal in October, for example, it initially sought to pay a 2% coupon on its three-year deal, but accepted it would have to pay closer to 3% in the end. “When the market started, ICBC was issuing a two year bond at 1.1% and the market was lapping it up,” he says. “That will no longer be the case. Otherwise investors like ourselves are prepared to look away, buy in the Asian dollar space, and switch it back to RMB.”

Fund managers have taken a number of different approaches to the RMB market. Many of the earliest players were local, and these have tended to be more comfortable with credit. Haitong International Asset Management, for example, launched the first RMB fixed income mutual fund in Hong Kong in August 2010, following it with a private placement fund and has announced a dedicated high yield bond fund, with classes in RMB for Hong Kong investors and dollars for overseas, targeting a yearly return of 7-8%. (Haitong did not respond to requests for an update on the fund’s progress before Asiamoney’s deadline.)  Citic Securities International launched a hedge fund structure in this area, the CSI RMB Fund, which takes on multiple strategies including foreign exchange, interest rate and fixed income securities in RMB.  Earlier this year it was talking about 15-20% annual returns, including the currency appreciation; however Citic told Asiamoney it was no longer allowed to talk about the fund for regulatory reasons.

Some internationals have opted to go to the other end of the spectrum and stick with high grade. Barclays is an example: its UCITS-compliant fund will always be investment grade, on average. “There were a lot of funds launched between November 2010 and March of this year, many of them out of Hong Kong from onshore Chinese managers with a presence offshore,” says Faddy. “A lot of them are credit funds, looking to pick the eyes of the high yield market. There was a time when a lot of companies who were finding it difficult to source funding onshore could do so offshore – you could get almost anything you wanted away at a price – and several funds were set up around what was happening in the market at that time. We took a different route.” In his view, the opportunity is among deposit holders who want to get a bit extra without risking the lot. “We are really looking to provide depositors with an alternative,” he says. “Depositors have been attracted to the letters RMB, but the bank deposits carry low rates; the next iteration for those depositors in their investment life cycle will be looking for yield. A high quality portfolio of the bonds is the best alternative for depositors.”

Still others will venture into high yield, but with strict criteria around what they buy. “We would consider any bond that comes on to the market,” says Lunt at HSBC. “There are very good high yield issues available in CNH.”  But “We are absolutely determined not to invest in anything we don’t fully understand. Unrated issuance isn’t necessarily of a lower quality, but it’s very important in this market to have a very strong credit analysis platform and process.”

That will also be the attitude of the BlackRock fund when its new fund arrives. “It’s less that we feel that every high yield issuer is going to face problems; it’s more that there are some names that offer good value, and others that are less compelling,” says Neil Weller, portfolio manager.

Some internationals have taken the approach of mixing RMB bond exposure with other opportunities. In this respect, the UBS RMB Fixed Income Fund is interesting. The fund can only invest in investment grade bonds, and must maintain an average duration below three years. “Based on these two investment restrictions, we can cut down the credit and interest rate risk in the portfolio,” says Ben Yuen, head of fixed income for pan-Asia, at UBS. But against these restrictions, it can put up to 20% of its assets into US dollar Asian investment grade credit, and hedge it back to RMB. “Why? Because the market is quite green, and the universe is small for the offshore RMB bond market.” At the time of writing 18% of the fund’s NAV was used in this way.

Another distinguishing factor is that the fund can invest in RMB deposits, allowing it to invest in futures when they provide a better potential return for the portfolio. This is useful because of the way the market has been behaving: the spread between a five-year government bond in CNH and CNY is about 1.8%, but as recently as July stood at 3.4%. That sort of movement creates opportunities in futures markets.

This approach is helpful when there is high demand for primary securities. “We are not going to force ourselves to invest all our assets in bonds,” says Yuen. “We are holding short term paper to allow us to pick up higher CNH interest rate opportunities in futures. Our short-duration strategy seems quite effective in this market environment.”

Not everyone is sure these arbitrage gyrations are the right place for fund managers to be. “It’s something you’ve got to be very careful with,” says Weller at BlackRock. “The positioning is prone to get very stretched, and at times of illiquidity we’re all aware of what can happen when everyone is positioned the same way around.”

UBS’s approach of allowing some investment in Asian dollar paper is also used at Fullerton. About 25% of the fund is invested in this way. “It gives us a bit of enhanced liquidity, as I the dollar market is more developed,” Yue says. Unlike the UBS product, though, Fullerton can and does invest in high yield, and even unrated bonds; like HSBC, Fullerton assigns a credit rating to any security, and will do so through internal credit work if external ratings are not in place.

The market continues to face teething problems; one widespread complaint is that there is no investable benchmark available. But as the market develops, issues like this will be ironed out. The next characteristic is likely to be a growth in UCITS structures, reflecting increasing demand for these assets progressively further afield from Hong Kong. RMB is, increasingly, a global story.

BOX: RMB and gold

As the offshore RMB bond market has developed, more and more investment classes have grown around it. In October another was added: gold.

The Chinese Gold & Silver Exchange in Hong Kong launched the world’s first offshore RMB-denominated spot gold contract in order to attract some of the RMB circulating outside mainland China. “This product will help with that circulation, rather than the money having to stay in deposits,” says Haywood Cheung, president. Trading has to go through an exchange member – of the 171 members of the exchange, 27 had registered to trade this new contract as of late October – suggesting that initially much of the interest may be from people who physically need the gold, such as goldsmiths and jewelers. That said, there is an electronic platform for trading too, with leverage available of up to 20 times – and the ability to leverage RMB may prove the most attractive element to mainstream investors.

Part of the appeal is that both gold and RMB are perceived as safe investments. “Investors recognize gold as a safe haven, and if the gold is denominated in RMB they are double safe-guarded, because the RMB at this moment is a stable currency,” Cheung says. “It’s a win-win case.”

In the offices of Hong Kong’s banks and fund managers, a transformation that will shape the world economy is in its early stages. This is the slow but steady process of turning the Chinese renminbi (RMB) from a heavily restricted currency to one that is open and internationally traded. The endgame, many believe, is an international reserve currency to rival the US dollar – and is perhaps not far away.

China today is at a halfway house between restriction and openness: a middle ground in which the current account is open and the capital account closed. It’s a situation that has created some quirks – one currency behaving in a wildly different way depending on whether it’s onshore or offshore – and a host of opportunities besides. The big topic of discussion in Hong Kong, and elsewhere in Asia, is where it goes from here.

To see this article as it ran, click here: Half open door

[Subhead] Slowly opening the door

For most of China’s modern history, the RMB has been a purely domestic currency, tightly controlled by the central bank, the People’s Bank of China (PBOC). When Chinese companies conducted business with foreigners, the trade would be denominated in US dollars and pass through the PBOC.

The first hint of a change of heart came in 2003, when personal banking services in RMB were permitted for Hong Kong residents – a largely symbolic gesture that went no further than deposit accounts and a handful of credit cards. The next came in 2007, when a handful of mainland Chinese financial institutions, starting with the China Development Bank, were allowed to issue RMB bonds in Hong Kong; the next year a handful of foreign banks incorporated in China, such as HSBC, were allowed to do the same. And in July 2009 China tried out a pilot trade settlement scheme, allowing five coastal cities to settle their trade with Hong Kong, Macau and southeast Asian countries in RMB.

But the big steps came in 2010. First, the Hong Kong Monetary Authority – Hong Kong’s central bank – said that any institution permitted to issue a bond in Hong Kong (that is, more or less anybody) would also be permitted to do so in RMB; shortly afterwards, limits on Hong Kong-based companies converting RMB, or launching investment products in the Chinese currency, were removed. At a stroke, this created a whole new capital market: the so-called dim sum bond market.  In the three years up to June 2010, when only policy institutions and the big banks could issue, a total of RMB34.3 billion in bonds were launched; 12 months later, gross issuance had quadrupled to RMB138 billion (outstandings were RMB175 billion as of early September). “Over the next three to five years, the total size of the market might reach RMB1 trillion, which would be close to 50% of the whole Hong Kong dollar debt market,” says Linan Liu, Greater China rates strategist at Deutsche Bank.

On the trade settlement side, the original five-city pilot scheme has been steadily extended – first to 20 cities, then wider again, and finally in August 2011 to the entire country. So any transaction between a Chinese and an international partner can now be settled, outside China, in RMB.

The latest round of liberalization came when China’s Vice Premier Li Keqiang came to Hong Kong on August 17 this year. It was a pivotal moment: what he said would give a clear indication about whether China was comfortable with or alarmed by the pace of internationalization of its currency, and where it would go next. The vote came down firmly in the positive. “Not only is Beijing still comfortable with the rapid pace of offshore RMB market development, but it is taking the process to the next stage,” says Donna Kwok, economist at HSBC. Among other things, he said that Hong Kong enterprises would be allowed to invest RMB back into China through foreign direct investment. This is crucial, because until now, while it has become increasingly straightforward for money to leave China, it’s been rather difficult for it to find any way to go back in again and serve any useful purpose.

So that’s where we stand today. But what don’t we have? The main thing that’s missing is convertibility in the capital account, which is one of the reasons that so far most of the flow across borders in RMB has been in one direction, outwards from China. And this arrangement is having some peculiar effects.

[Subhead: The strange case of the RMB]

Onshore and offshore RMB are referred to in a shorthand in the Asian financial industry: CNY for onshore, CNH for offshore. And ever since people started to distinguish between the two, they’ve been behaving in radically different ways. Offshore, interest rates on RMB-denominated assets are low, and have been falling, because there is far greater demand for ways to invest the currency than can currently be met. Onshore, interest rates have instead been rising. Traders have spotted an arbitrage, but it’s already making some bankers uneasy. “CNH doesn’t exist except in our heads,” says an Asia country head of a major western bank. “We are all for helping China in what I think it means to do, which is to make the RMB an international currency of trade and settlement. But the arbitrage… I’m saying to our wealth management people, be very careful, because if all this unwinds, you’ve got nowhere to turn.”

The sense of a strangely artificial environment also exists in foreign exchange. There are now three separate FX markets for exactly the same dollar-RMB trade: the onshore market; a non-deliverable forward market, which is how foreigners used to trade the currency before this process of liberalization; and now CNH, or offshore RMB. And there are pricing discrepancies between them, which again traders are seeking to exploit – probably not what China had initially intended.

But the biggest impact of this halfway open door has been an intense supply-demand imbalance which has had a major impact on the way the offshore RMB bond market has developed. At its heart is the pace with which RMB deposits have accrued in Hong Kong: from just RMB90 billion in June 2010, they had risen to RMB572.2 billion by July 2011, according to the HKMA. Before a recent slowing, they had been growing consistently at 10% per month.

These deposits need somewhere to go: they earn almost no interest sitting in the bank, so the holders of this cash are anxious to find a return. And this is the dynamic that underpinned the growth of the offshore RMB bond market: the dim sums.

[Subhead]The dim sum boom

In the early days after the July 2010 liberalization, the issuers were natural borrowers: Hopewell Highway Infrastructure, McDonald’s (which needs RMB for mainland expansion), China Resources Power. But as the sheer level of demand and pricing power became clear – the Ministry of Finance paid just 1% for a three-year bond in November 2010, in a deal that was still 10 times oversubscribed by institutions – more and more companies decided they should issue too. By the end of the year, issuers had included Galaxy Entertainment Group – an un-rated Macau casino developer – and the Russian bank VTB. While there’s nothing necessarily wrong with either of these names, they were able to raise money at dramatically lower yields then they would have had to pay in the dollar markets. At the same time, low-rated Chinese issuers (or generally their Hong Kong subsidiaries), particularly property developers, began to jump in. The market had gone from top-ranked government-backed banks to high yield issuers within a matter of months.

It didn’t take long for this to become alarming. Lawyers who have dealt with Chinese high yield issuers in the dollar markets are familiar with many dangers in buying their debt; in particular, investors often find they have absolutely no security over assets in China. “Exactly the same issues in relation to taking of security arise whether the bond is denominated in RMB or not,” says Joseph Tse, partner at Allen & Overy in Hong Kong. “But with RMB bond issuance there is an extra layer of regulatory issues separate from the security issues,” particularly around repatriation of proceeds. Yet investors, so keen to get a decent return on their money, didn’t seem to be seeking any covenants from issuers. “The market seems to have accepted that it can get comfortable with no security from these companies, particularly those which are listed,” Tse says. Another lawyer is more blunt: “Some of the deals coming out of China earlier this year were restructurings waiting to happen.”

Why the clamour? Investors aren’t just after the yield on the bond: they also believe strongly that the RMB is going to continue to appreciate against the dollar, and they factor that expectation – commonly 3-5% or so per year – into any decision about buying a bond. But the supply-demand imbalance is not really healthy for anyone. “Growth of 400% in the past 12 months [in offshore RMB deposits] is pretty spectacular, and that created the demand side of the supply-demand imbalance which is how the market developed,” says Eric Greenberg, managing director, financing group and head of leveraged finance in Asia ex-Japan at Goldman Sachs. “Out of the gate, because offshore RMB was receiving such low interest rates from the banks, it made RMB offshore bonds that much more attractive for investors. That meant an inefficient market, with longer tenor, loose covenants, and at rates below which one could borrow in onshore RMB.”

This is one reason that the August announcement around allowing RMB back into China as foreign direct investment is so important: by finding a way to recycle the Chinese currency back onto the mainland, it may relieve some of this supply-demand pressure. Already, bankers feel that some balance is returning to the market. “In the last few months the market inefficiencies have started to narrow as there has been some pushback from investors and the forward curve for RMB appreciation has come down,” says Greenberg. While retail and private banking clients have focused on enhancing their deposit yields, Greenberg notes a stronger price and covenant discipline among institutional buyers now. On top of that, one of Vice Premier Li’s other announcements in August was that all Chinese companies will now be able to launch offshore bonds, which should help to increase the available pool of issuers, creating more competition, higher yields, and a better deal for investors. “The demand and supply situation is beginning to correct itself,” says Rita Chan, an executive director at Goldman Sachs. “That is reflected in more scrutiny around whether the bonds are rated by international agencies, how liquid the bonds are, and whether the issuer is listed. We’re moving towards a true Regulation S standard rather than – as it was in the first half of this year – everything can sell.”

Another shift that might help to redress the balance is if investors’ views on the currency change. Expectation of a climb in the RMB is near universal, but as the world economy has deteriorated – hitting Chinese exports – expectations of the pace of that climb have become more conservative. “Earlier this year, people were expecting 2 to 3% appreciation per year for the next five years,” says Chan. “That was one reason they were so enthusiastic about investing. But over the past few months the forward curve has shifted around.” Greenberg adds: “Currency movements have helped to evaporate some of the market inefficiency.”

From an investor perspective, the allure of RMB assets remains very clear, and any change in supply-demand imbalances is in their interests. ““For investors in CNH, just like elsewhere, you need to form an opinion about the strength and quality of the investment,” says Li Cui, chief China economist at RBS. “In particular a lot of bondholders are attracted by the longer-term strength of the currency. What’s attractive about the RMB is China’s economic and trade size, the potential growth, much healthier balance sheet, and importantly macro stability, which bolsters confidence in the currency.”

And investment in these bonds is no longer just restricted to Hong Kong retail investors and institutions with a backlog of the currency to put to work. Across Asia, the private banking community is finding ways to get positioned.

“Given what is happening in Europe and the US, I think that is ultimately going to force the Chinese to speed up the internationalization of the RMB,” says Dr Lee Boon Keng, head of the investment solutions group in Singapore for Swiss private bank Julius Baer. He expects continuing RMB appreciation, more and more foreign institutions issuing offshore RMB debt, and a much faster liberalization of the capital account than many expect: “maybe a couple of years, instead of a couple of decades. It makes the Chinese growth story that much more compelling.” He considers the loosening of the Chinese currency “a megatrend.”

In positioning his clients for it, he has worked with Asian bank DBS to launch a fund that invests in offshore RMB bonds, and is also encouraging investors to look at the Chinese stock market. “I’m telling clients that the equity market is at valuations last seen in 2005. This is a great opportunity. Why are you waiting for that minus 10 or 15% potential drop before you dip yourself into the water? We may have bottomed out already.”Julius Baer has QFII quota from China – a system by which foreign institutions are permitted to invest a set amount in the mainland Chinese market – and is using it to launch a fund investing in both A-shares (Chinese domestic securities in RMB) and H-shares (Chinese companies listed in Hong Kong and traded in Hong Kong dollars).

Another opportunity that will evolve for investors is RMB-denominated IPOs in Hong Kong. There has only been one so far, a real estate investment trust (REIT) issue for Hui Xian REIT, a subsidiary of Hong Kong conglomerate Cheung Kong Holdings, in April; it didn’t go especially well. But in due course this will likely evolve into another major market. Elsewhere, mutual funds built around RMB assets are beginning to spring up, while in the other direction, Chinese clients will soon be allowed to invest in exchange-traded funds (ETFs) in Hong Kong.

[Subhead] The future

So where is this all heading? There are still some who don’t believe that China is looking for full convertibility. “Allowing Hong Kong to develop RMB offshore product doesn’t necessarily mean China wants to open the capital account,” says Christopher Wood, strategist at Hong Kong-based brokerage CLSA and author of the influential Greed & Fear Report. He describes the growth of the market as “more from the political desire to give Hong Kong a new toy.” He won’t be convinced full liberalization is coming until banks are able to lend RMB offshore, and in any case doubts that full openness would be in China’s interests anyway. “The PBOC will lose control of the whole system if they open the capital account.”

He is, though, in something of a minority. “I strongly believe full convertibility is the goal of internationalization,” says Liu at Deutsche. “Post financial crisis there is a growing recognition that growth should be less dependent on the US dollar in trade, the pricing of commodities and reserve management.” She thinks that there are “five to 10 years of structural reforms needed in the domestic market” before China will be ready for full openness, to address issues around the onshore banking sector, but that at the right time “I would definitely look to the RMB to become a global reserve currency. Not to challenge the dollar or euro, but to be one of four major currencies in the global FX system [the other being the yen], with the RMB hopefully one of the main currencies for emerging countries.”

Some feel that this ambition – a reserve currency, strongly reducing China’s exposure to a declining dollar in which it already holds more than $3 trillion in reserves – is why China is willing to tolerate the oddities and arbitrages that inevitably come with the process of gradual opening.

Others think that far-fetched. Cui at RBS says the RMB as a reserve currency is “still quite some time away,” and not really the point of liberalization. “In the near term, the main aim is to boost its role as a vehicle currency for trade and investment.”

She says a lot needs to be done in the domestic financial system before full convertibility will appear sensible to China, and others agree with her. “For the RMB to be fully convertible, we have to make sure China’s financial market is ready,” says John Sun, executive director, fixed income, at Citic Securities International. “All the banks must become fully market-driven businesses, as with convertibility the financial system will be opened to foreign markets directly. At this moment, the financial market in China is not robust enough to do that. It’s not going to happen in the next three or four years.

“And if the RMB cannot be fully convertible, then it cannot become a reserve currency for a relatively long period of time. I don’t see the possibility in five years or even longer.”

Still, the wild card in all of this is how the deterioration of the US economy and currency is seen in China, and whether it may force the country’s hand to move faster than it had at first intended. “I still have confidence in the US economy: it is still two and a half times larger than China’s,” says Sun. “Having said that, there is a global problem with US dollar depreciation, because of the trouble it causes in commodity prices and export inflation from the US to other countries. No currency, including the RMB, can replace the US dollar, but a lot of countries are going to try to find a better way to make their financial markets more stabilised.” And that could be a catalyst to faster change, and a new world currency.

ENDS

KNOC

Korea National Oil Corp (KNOC) launched a US$1 billion five-year bond early Thursday morning (Asia time), which some billed as a market re-opening deal, and others as an opportunistic use of a brief window.

This was the first dollar benchmark from Asia for more than a month, since fellow Korean borrower Kexim raised US$1 billion. Its reception was closely watched, and considered successful, though some in the market suggested the issuer may have overpaid.

The deal, led by Barclays Capital, Bank of America Merrill Lynch, HSBC, KDB and Royal Bank of Scotland as joint bookrunners, was about eight times subscribed during a 12-hour bookbuild with bids from more than 400 accounts. It priced at 310 basis points over Treasuries, which was inside initial price guidance of 330bp over; yield was 4.137%, based on a 4% coupon and a re-offer price of 99.387.

KNOC is a powerful, closely-watched and state-backed institution, but not a truly top-tier borrower in terms of rating; it is rated A1 by Moody’s and A by Standard & Poor’s. Nevertheless, any state-backed investment grade name borrowing in size is an influential trade, particularly since investors tend to see KNOC as exposure to the Korean state in general. “With the strong credit profile and strategic importance to Korea and the Korean economy, KNOC was able to successfully access the US$ market while a number of other Asian issuers in the pipeline remain sidelined,” said someone close to the deal.

Rival bankers were pleased to see a deal of this size get away, though there was some carping about whether the initial price guidance was wider than it needed to be, and opinions varied on the true significance of the deal.

“This is a market re-opening trade for Asia,” said someone close to the deal. “It was the first trade in benchmark size in hard currency for about six weeks and it has provided a lot of confidence to the market. It left a positive taste in everyone’s mouth.” Another added: “The transaction marks the reopening of the Asia ex-Japan US$ public primary market.” One bookrunner said that there was “certainly a good number of issuers looking at the markets” in light of the deal’s success, while noting that the timing was key. “Today’s market was on the back foot again,” he said, speaking on Thursday afternoon, Asia time. “The transaction would not have worked in the same shape or form today.”

But others were not so sure about its long-term impact. “It is good to see this get away, but the problem is you still don’t have any certainty about what is going to happen next in Europe, and one bad headline can destroy any confidence in the market,” said a banker. Another said: “I wouldn’t go so far as to say that this reopens the market for everybody.” Bankers both on and off the deal agreed that the outcome of Sunday’s summit on the eurozone would be key to subsequent issues.

On pricing, KNOC’s existing bonds due 2015 were trading at around 270 basis points when the deal priced, meaning that the initial guidance in particular – if not the final price – constituted a considerable new issue premium. “That initial guidance was a new issue premium of 60 basis points – that’s very, very wide,” said one banker. “That’s a no-brainer for investors. A book of $8 billion for $1 billion of issuance is insane. So could they have got away with starting out at a tighter price?” The deal tightened in the aftermarket and was trading at around 298 bp over Treasuries, a tightening of 12 points, on Thursday afternoon.

Those close to the deal defended the pricing, noting that a tightening of 20 basis points from guidance was impressive given the market conditions. “The initial pricing point was partially based on investor feedback, and partly based on what we have seen in the markets globally in terms of new issue premiums, in the 144a space and global emerging markets as well,” said someone close to the deal.

The deal sold chiefly to Asia (44%) and the USA (40%), with European investors more subdued (16%). More than half the book went to fund managers (57%), with the remainder being taken up by insurers (18%), banks (14%), retail (6%) and central banks and other public institutions (5%). The senior unsecured deal carries a put at par if at any stage the Korean government’s level of ownership drops below 51% of the company. The transaction formed part of KNOC’s global MTN programme, recently expanded from US$4 billion to US$6 billion. It followed a non-deal roadshow in September that took in global fixed income investors in Asia, Europe, the Middle East and the US.

Investors continue to show interest in commodity-related businesses, seeing them as resilient to market shocks; last week Standard & Poor’s issued a note saying that “the recent downturn in crude prices may be discomforting for Asia-Pacific oil and gas companies, but it’s unlikely to affect credit ratings.” Many oil and gas companies achieved solid earnings in the first half of the year, the report said, creating a buffer if cash flows decline over the next 12 months.

S$

The Singapore dollar bond market enjoyed a flurry of activity this week, with new or tap issues from Wharf and Cheung Kong (Holdings), and a third issue underway from Standard Chartered. The deals reflect the relative stability of the Singapore dollar as a funding market despite global volatility.

The Cheung Kong deal, one of two from Hong Kong heavyweights during the week, was a tap of an earlier S$500 million perpetual issue launched in September. The tap raised a further S$230 million through DBS and JP Morgan, who were also joint bookrunners on the original deal.

The tap attracted S$300 million in a one-day accelerated book-build. In keeping with many Singapore issues, the largest part of the buyer base was private banks, accounting for 75% of the allocation, followed by asset managers with 11%, insurers 10% and banks 4%. By region, it was overwhelmingly locally placed, with 92% staying in Singapore.

Bankers are turning to the Singapore dollar as its safe haven status and a steady investor base protects it from turmoil in the US dollar markets. “After the initial Cheung Kong deal [in September] there were a number of negative events out of Europe, and the credit market by and large shut down for new issues,” said someone close to the deal. “But I would say the Sing dollar perpetual from Cheung Kong was one of the securities that held up reasonably well. Since late last week the market has staged a rally in credit, and the perpetual is back up to par. So it was very opportunistic, from the borrower’s perspective, to see market stability and to go back to the bond again.”

Earlier in the week fellow Hong Kong group Wharf Holdings had priced a S$250 million issue of seven-year bonds, increased from an initial target of just S$100 million after the books were three times covered. The deal, also led by DBS, paid a coupon of 4.3%, representing the low end of guidance. This deal was even more heavily dominated by Singapore buyers than Cheung Kong, selling 96% locally, although in this deal banks were the biggest part of the book at 41%, followed by 27% insurers, 20% private banks and 12% asset managers.

And on Thursday, Standard Chartered was in the market for a 10-year non-call five Singapore dollar benchmark, although the size of the bond was unclear as Euroweek went to press. Guidance was around 4.25%. Investors said they considered this as equivalent to a 35 basis point new issue premium versus fair value, and therefore attractive.

Why the activity? “Between the major markets in the Asia credit space – primarily the Singapore dollar, CNH and US dollar – the markets that are functional are the CNH and the Sing dollar,” says one banker. “There, you are still seeing trades getting done at the right price. It’s a contained market, anchored by strong local bids from private banks or insurance money; there are not many investors but it’s resilient.”

Dim sum

The CNH “dim sum” bond market sprung back into life this week after a three week hiatus. A RMB3 billion two-tranche raising by China National Petroleum Corp (CNPC), which owns PetroChina, was the most significant deal and is likely to herald a round of new issues.

The CNPC deal was made up of a RMB2.5 billion two-year tranche and a RMB500 million three-year. The two-year had a 2.55% coupon to yield 2.6%, and the three year 2.95% to yield 3%. HSBC and Bank of China were joint global coordinators, joined by Deutsche and ICBC as joint bookrunners.

CNPC was seen as an ideal name to reopen the market after a brief hiatus; it is rated Aa3/AA-/AA- and is the highest-rated Chinese corporate to have sold RMB-denominated bonds in Hong Kong. “It’s viewed very much as the next best thing to the sovereign,” said someone close to the deal. “It’s about as good a name as you’re going to get in Asia to start the market off again.”

The market had become slightly becalmed in previous weeks following a flurry of issuance from names including BP, Tesco, Air Liquide and BSH Bosch und Siemens. “At that point, the CNH market suffered what G3 markets had been suffering,” says one banker. “You had had a couple of weeks where the CNH market was working when other markets were not; at that point investors said ‘enough’s enough’ and took a big step back.” The CNPC deal had to move quickly when markets improved: a decision was made on Monday, then two roadshow teams presented simultaneously on Tuesday, one each in Singapore and Hong Kong. Work began on Wednesday with a 6.30am call with the issuer before bookbuilding began, concluding late on Wednesday night following lengthy debate on allocations. The deal was almost three times covered and received almost 100 orders.

While the deal was a success, those close to it notice that a change has taken place in investor sentiment towards CNH bonds, partly because of changed expectations about the likely performance of the currency itself. “Investors were previously saying they don’t mind a very low coupon and bond yield because they were expecting 3, 4, 5% of currency appreciation. That was a generally accepted view of the markets in the first half of the year,” said one banker. “It’s not the case now.” Alongside that, investors have become more cautious. “It’s a good thing for the market, because it means investors are starting to look at credits and comparing one against another: they like this name at this level, don’t like that name at that level. Earlier in the year, it was: I’ve got loads of CNH I need to put to work so let’s buy loads of credit bonds, because something is better than nothing.”

The CNPC deal followed a landmark dim sum sukuk from Khazanah Nasional, covered in Euroweek’s daily coverage on October 14; it raised RMB500 million in a three-year deal. The question now is what other issues will follow, since many bookrunners report a full pipeline representing a variety of credit quality.

First impressions are that strong and familiar names will appear soonest. For example, approvals have been passed for up to RMB40 billion of RMB-denominated subordinated debt by China Construction Bank, although clearly not all of that would be expected to appear in the dim sum markets; and Baosteel Group has received approval to issue up to RMB6.5 billion of dim sum bonds. But bankers suggest a range of potential issuers. “Will the next issues just be the good quality names? The first one or two, maybe, but there’s quite a lot in the pipeline at the lower end of investment grade,” says one DCM banker.

Another adds: “I don’t think this is a fully reopened market. I don’t think the floodgates are open and the whole pipeline will pop out in the next two to three weeks. But having had a correction, and with levels readjusted, investors do have money they are willing to put to work.”

Covered bonds
The long-awaited Australian covered bonds market has reached the starting line. Key legislation is now in place, with two of the country’s biggest banks preparing to hit the road to market landmark new issues.

Last week the Australian Banking Act Amendment, the enabling legislation for covered bond issuance from Australian deposit-taking institutions (ADIs), passed through parliament, receiving Royal Assent earlier this week. This concludes the legal side of the process. “The legislative approvals have now happened,” says Pierre Katerdjian, global head of credit markets at Westpac. “It basically means that Australian ADIs are able to issue covered bonds.”

That is not quite the whole picture, however. “The other leg is the prudential piece: APRA [the Australian Prudential Regulatory Authority, Australia’s banking regulator] has to amend APS 120, to create a framework for banks to issue,” says Katerdjian. “There will probably be a draft out in mid-November with a formal release in the new year.” But the fact that APRA’s prudential standards are not yet out is apparently not enough to stop issues beginning. “What APRA has said to the ADIs is basically: you can issue, but be mindful that we’re still finalizing the new APS rules.”

Banks have taken this to heart, and National Australia Bank and Commonwealth Bank of Australia are already preparing to market new issues. Both are expected to travel to the US and Europe, raising the prospect that they may make their maiden issues with tranches in both euros and dollars. NAB is understood to have arranged meetings starting from October 31, through Deutsche Bank, JP Morgan and NAB itself; Commonwealth Bank of Australia will be one week behind it, led by BNP Paribas, Morgan Stanley and CBA.

Neither is yet clear on the likely launch date for a deal, nor the size or currency. But the market expects to see them sooner rather than later. “I expect lawyers are drafting program documents and you will probably see the first deal launched in mid- to late November, subject to market conditions and regulatory approval,” Katerdjian says. “Into which jurisdiction they [CBA and NAB] issue is not yet clear given the early stages of the roadshows, but you would expect ADIs to issue covered bonds in both currencies over time.”

Both banks, and Australians generally, are likely to find a warm welcome in markets that have otherwise become somewhat cynical about the health of the banks who try to borrow from them. “It is very significant, first of all because the Australian banking system is in good shape and one of the safest banking systems in the world,” says Ted Lord, head of European covered bonds at Barclays Capital. “At a time when you have extreme market volatility and talk about a forced recapitalization of certain banks, it is nice to have a potentially large market open up where these issues are not the focus of attention. Investors are very keen, and Australians have a history of tapping into different capital markets around the world.”

Legislation limits covered bond issuance to 8% of total assets by any one Australian bank, but that still represents an extremely large potential pool of capital raising. “It depends on how successful the first issues are,” Lord says. “If you add up the assets that could potentially be raised, you have a potential issuance volume of around A$125 billion before you reach the ceiling – there’s a lot of scope there. Also the Australian covered bond market offers one of the few markets with the potential to build full curves in a variety of currencies.”

However, Katerdjian adds that Australian banks will have to make careful considerations around their volumes of issuance into a new offshore market, since that is already an area of scrutiny in a review of the Australian banking sector underway by rating agencies. “The expectation is, given market dynamics and liquidity treatments offshore compared to domestically, that we will see most ADI covered bond issuance go offshore. Balancing this has to be the hot topic of the offshore vs onshore wholesale funding mix for ADIs, particularly given the pending ratings agency reviews,” he says.

In the market’s favour is the fact that the Australian government is likely to support it if it means a better outcome for the local consumer.  “This is a market that should not only have legs but continue to grow,” Lord says. “It should be seen not just as a strategic move for banks who want to issue covered bonds. The government is realising that this is a viable market that could help with funding, and hence help the Australian population with lower mortgage rates.”

Even by the exuberant standards of the offshore RMB debt markets, synthetic RMB – a market within a market – has had an extraordinary life. Invented only in December, it has thrived, broken records, and then apparently faltered again, all within six months.

It all began with a remarkably successful deal in December for Hong Kong-listed Shui On Land: the first straight bond to be launched in RMB, but settled in dollars.

Shui On Land is a solid name, but the scale of demand it attracted – an RMB32 billion (US$4.81 billion) book for a deal that had been marketed at RMB1.5-2 billion – surprised everyone. Shui on and its bookrunners, Deutsche Bank, Standard Chartered and UBS, increased the three-year deal to RMB3 billion and still had to scale orders back tenfold. Shui On, it is worth remembering, doesn’t have a credit rating.

The appeal of the synthetic format to investors was very clear. It allowed them to gain exposure to movements in the RMB, which are universally expected to be upward; and it did so without the investor having to navigate the swap markets should they hope to turn the investment into their home currency. The lack of depth in the swap markets had already, by December, become a clear potential bottleneck for RMB issuance. Dollar settlement also got around some restrictions global investors might face.

From the issuer perspective, it gave them an alternative method of reaching funds; at that time property companies had been struggling to access the dollar high yield markets (though they would regain momentum early in 2011). It avoided creating RMB proceeds in Hong Kong that may be troublesome to remit to the mainland. And the yield, while higher than on pure RMB dim sum bonds, was generally more attractive from an issuer point of view than a dollar bond would be. Shui On paid a yield of 6.875% (having tightened from guidance of 7-7.125%), which is higher than typical dim sum yields (unrated Macau casino operator Galaxy Entertainment had borrowed at 4.625% earlier in the month) but lower than the likely 8.5% or more it would have paid in the dollar markets. In deciding whether to buy, investors are clearly factoring in the likely increase in the value of the RMB itself as part of the equation.

While several issuers had previously conducted RMB-denominated, dollar settled convertible bonds – including Country Garden and Shui On Land itself – the new synthetic bond was seen as a momentous development for the market.

After Shui On, the floodgates opened. On January 7, China SCE Property raised RMB2 billion in a five-year dollar-settled bond through HSBC and Deutsche, paying 10.5%. Like Shui On, the deal was upsized and tightened along the way. China SCE is rated B1/B+, and its bonds B2/B; analysts said at the time that it would have paid around 13% for the same deal in dollars.

The following week came the biggest deal yet: Evergrande Real Estate Group, another Chinese developer, raised RMB9.25 billion (US$1.4 billion) in a synthetic dual-tranche deal. Just weeks after this part of the market had been launched, Evergrande had launched the biggest ever high yield bond in any currency from a Chinese property company. “The size that Evergrande have achieved in synthetic RMB is phenomenal: US$1.4 billion equivalent, which is by far the largest Regulation S deal ever seen for a high yield credit,” says Terence Chia, in debt syndicate at Citi, one of four lead managers on the deal alongside Bank of America Merrill Lynch, BOC International and Deutsche Bank.

Everything about this deal was dazzling. Its order book came in at RMB33.1 billion; 136 orders came in for the RMB5.55 billion three-year tranche, and 108 for the RMB3.7 billion five-year; and at 7.5% for the three year and 9.25% for the five year, in line with guidance, it was strikingly cheaper funding than the 13% Evergrande had paid for a $750 million five-year global one year earlier.

For Parry Tse, Evergrande’s CFO, the contrast between the two bonds was very welcome – and not just because of price. “In terms of procedure, they were very different,” he says. The Rule 144a bond in January 2010 required “three or four weeks” of preparation to meet the various regulatory requirements, he says. “When we issued a synthetic RMB bond, the majority of investors were located in Hong Kong and Singapore. Investors in this region have a better expectation of the appreciation of the RMB, so were very interested to purchase RMB bonds. Because we did not need to go to the US for marketing, it only took two weeks of preparation work. It saves a lot of time.”

And so other issuers began queuing up. Later in January Shui On Land came back again, just five weeks after inaugurating the market, raising RMB3.5 billion of four-year paper at 7.625%, through Deutsche Bank, Standard Chartered, UBS, Barclays Capital and BNP Paribas. It attracted RMB17 billion of demand from more than 150 accounts. And Kaisa Group raised RMB2 billion in the first private placement of synthetic RMB bonds.

But after Evergrande, whose immediate secondary market performance was poor, sentiment in the market had started to change.

In February, the Chinese solar wafer maker LDK Solar raised RMB1.2 billion in three-year bonds settled in dollars, with a yield of 10%. Those numbers look solid enough, but the atmosphere around the deal was very different to those that had preceded it: it was downsized from RMB1.5 billion, and the yield had to be raised from a planned 8-9%. Even at those levels it was barely oversubscribed, and then dropped in the secondary market.

The deal, lead managed by Citi and Morgan Stanley, ran up against several headwinds: a tightening of reserve requirements shortly after the deal began trading, which was part of the reason for the drop in the secondary market, for example. And an unrated issuer in a new technology area was difficult to sell at the yields the borrower appeared to want.

Also, the deal did subsequently bounce back somewhat in the secondary market. But it was the first black mark against the synthetic RMB market, which really hasn’t recovered since. Around this time Country Garden successfully raised $900 million in a seven-year non-call four dollar bond, which then traded up, reminding people of the merits of longer-established vanilla markets. Names that had been expected to launch in synthetic RMB started to delay or cancel their trades; first Zhong An Real Estate, which had planned a Regulation S-only three-year bond in February, and then another for Global Dairy Holdings planned for April.

In fact, only one more synthetic issue has followed to date: from Powerlong Real Estate, which raised RMB750 million in three-year dollar-settled bonds in March through HSBC, Macquarie Capital and RBS. The coupon was 11.5%, priced at 99.383 to yield 11.75%. While this deal went well enough, it was notable that the pricing was just 200 basis points less than a dollar bond of the same tenor it sold in 2010, suggesting that the really big savings over dollar funding have already passed by.

Meanwhile mainstream dim sum bonds continue to thrive. By the time Guangzhou R&F successfully launched the first dual-tranche dollar and offshore RMB bond in April, it was clear that these markets were back in favour. Notably, by then, most synthetic bonds were trading below par, and most dim sum bonds, above. And so the market, worth about $3 billion in aggregate, is somewhat becalmed.

It’s interesting to look at who has bought synthetic deals. The Powerlong deal went 55% to private banks, for example; in Shui On and Evergrande, too, they topped 50% of allocation. When Powerlong had issued in dollars, private banks were 40% of the allocations, less than funds with 49%. These bonds clearly have a different, non-institutional target market to sell to.

It may be that the synthetic market dies away as some of the inefficiencies in the dim sum market that it seeks to remedy are resolved by the maturing of that market. For example, when longer tenor is available in dim sum bonds, when the swap market is more mature and repatriation of capital is easier, there will be less of a need for issuers or investors to consider the synthetic route.

Even issuers accept that the time in the sun may be fleeting, and that all RMB offshore bonds are benefiting from a currency play that may be temporary. “It may be a temporary situation,” says Tse at Evergrande. “You would expect the appreciation of the RMB to be vigorous in the next couple of years, but it will just be a transitional period. When the expectation of RMB appreciation is no longer so high, investors may not have the same interest in RMB bonds. The traditional US dollar bond market is still very important and will continue to be the main source of financing in future.”

The rise and subsidence of the synthetic market will eventually be seen as part of the broader market’s rapid evolution. “The China market was going down a two-pronged road,” says Henrik Raber, global head of debt capital markets at Standard Chartered. “Firstly the dim sum bonds, which started off as all local currencies do, being more oriented to high grade issuers, and as a mechanism to soak up some of the deposits building up in Hong Kong. Then, as the market started to develop, some of the dynamics around the market started to change: the US dollar market for Chinese high yield issuers started to get a bit weaker, and we started to see those issuers in the synthetic format.” Now, the dynamics are shifting again.

A debt market that has trebled in size in a year. An evolution in issuers from top-rated policy banks to high yield names, both Chinese and international, in the space of a few months. A trade settlement program that has gone from five coastal cities to more than 67,000 firms in two years. The formation of a new forex market and the launchpad for a new field of investment products. It’s not a bad start.

But what’s next for the offshore RMB?

The most obvious next step is more of what we’ve seen already. By May 20 this year, the total outstanding offshore RMB issues came to RMB103 billion, up from RMB34.3 billion just before the transformative new measures from the Hong Kong Monetary Authority came into effect and widened the range of potential issuers in July 2010. There’s nothing in the near term to stop that rate of growth. RBS predicts a total of RMB180 billion outstanding by the end of 2011, and if anything, that’s the conservative end: Vishal Goenka at Deutsche Bank expects RMB200 billion, across a range of issuer types.

It’s a safe prediction to expect further growth on this scale, because the body of capital that has created this new market – RMB deposits in Hong Kong – is growing just as fast. In June 2010, RMB deposits in Hong Kong amounted to RMB 90 billion; by the end of the year the figure was RMB315 billion and at the end of March, the most recently reported figure, it was RMB451.4 billion. At the moment, deposits are growing at 10% a month; RBS is calling RMB700-800 billion by the end of 2011, and HSBC RMB800 billion  to RMB1.2 trillion.  “Even if new issuance of CNH bonds in 2011 triples from the 2010 level, it will reach only 24% of the CNY deposit base,” says Woon Khien Chia, managing director and head of local markets strategy for emerging Asia at RBS.

With volume, it’s reasonable to expect a further evolution of the market. It’s already open to fairly low-rated credits, even unrated ones, but so far tenor is limited. It would be natural to expect that tenor to increase over time.

It’s also likely that some of the inhibitors of market development will be addressed over time. One of the most obvious of these is the process of remitting funds back to the mainland, a process that so far is slow, exacting and somewhat opaque. The State Administration of Foreign Exchange is likely to add more clarity and efficiency to the process if it appears, as it does, that the market is being damaged by the situation. Similarly, the swap market – an expensive and inefficient barrier to growth – should be expected to mature over time, and to become cheaper than the 250-300 basis points it typically costs today.

When those things happen, one knock-on effect may be the demise of the synthetic RMB market, which exists partly because of the problems of tenor, repatriation and swap in the dim sum market. The chapter on synthetics talks in more detail about how and why this might happen.

Another inevitable area of growth is in investment products for RMB outside China. Clearly, it’s already happening, but there is plenty of room for further development: not just RMB bonds but RMB life insurance products, derivatives, mutual funds and so on. Some feel that this might put pressure on the high yield issuers who are today making such remarkable headway with their issues: HSBC expects high grade issuers to be robust and underpinned by technical analysis, while high yield comes under pressure as alternative investment products become available.

On trade settlement, the pace of liberalisation has been particularly swift. It was only in June 2010 that an initial pilot scheme was expanded to 20 Chinese cities and to all foreign trade partners; then in December, the number of eligible Chinese participating firms was lifted from 365 to 67,359. But that’s still not everyone: the next step will be a further broadening of permission to cover all potential firms in China.

Whether that happens swiftly or not, we should expect a considerable increase in mainland Chinese businesses trading in RMB. RMB trade settlement took a while to get moving after liberalisation began, before real momentum became evident at the end of 2010, by which time the total RMB trade settlement value had hit about RMB486 billion. But this is just the start: HSBC has said it expects trade settlement volume to average at least US$2 trillion per year by the time RMB trade settlement hits critical mass.

HSBC Bank (China) announced the results of a survey in May which found that eight in 10 businesses in mainland China which do not currently use RMB to settle cross-border trade are planning to use RMB, or adopt it conditionally in future transactions. The survey covered 1,300 commercial banking customers across 18 mainland cities, a representative sample; 45% of them who did not have any experience in RMB trade settlement said they had plans to adopt it for future cross-border trade, and a further 33% will consider it depending on pricing and services offered by banks. In Shanghai, Beijing, Guangzhou and Shenzhen, 29% of respondents expect to adopt the RMB for trade settlement in the next 12 months.

The survey also found that 37% of mainland traders considered one major obstacle to be the acceptability of RMB among counterparties outside the mainland, and this is clearly another area for gradual evolution in future. It will require greater development of channels to use RMB they receive as payment, more support from banks, and greater education generally on RMB trade settlement. “These issues and challenges are inevitable as the RMB goes global,” Montgomery Ho, head of commercial banking at HSBC, says. “We believe that with the continued extension of the use and investment channels for offshore RMB, overseas markets will see a steady and continued rise in RMB holdings and strengthened local support for RMB settlement over time.” HSBC estimates that about US$2 trillion – more than half of China’s total trade – will be settled in RMB by 2015.

As an aside, one other interesting finding of the HSBC survey was that 49% of respondents that are already using RMB in cross-border trade said their main motivation was to hedge foreign exchange fluctuation risk, and another 44% said they hold RMB in view of its long-term appreciation.

Additionally, since August 2010, several foreign banks have been permitted to invest their RMB holdings into the China interbank bond market, with Standard Chartered, HSBC and Bank of China International in the first wave; another logical next step is further expansion of that permission to other banks.

In the longer term, another next step will be the resolution of anomalies that have developed from the way the market has been opened. Liberalisation has come at a time when the currency itself is still restricted on the capital account. That has led to imbalances in supply and demand, which in turn means that the same currency is behaving in two completely different ways according to whether it is onshore or offshore. Offshore, interest rates are low and falling because of demand. Onshore, they’re higher, and rising.

For the moment, this has clearly led to arbitrage possibilities. Strategists like RBS’s Chia believe that, while China doesn’t necessarily welcome the arbitrage that arises for issuers and traders, it accepts it as a necessary evil and part of the process of becoming a truly international currency – one that will, eventually, become an international reserve currency. “They know there will be some sacrifices along the way,” she says. Arbitrage possibilities will remain for at least a few more years, while money is tending to move outwards more than it is moving inwards, but eventually when two-way flows are more prevalent – and, ultimately, the capital account is liberalised – they will start to fade.

Related to this, it can’t always be the case that there are three separate foreign exchange markets for exactly the same cross-trade (RMB to US dollars), all behaving differently. There is, today, an onshore deliverable forward curve, a non-deliverable forward market, and now an offshore deliverable market for dollar/RMB spots and forwards. HSBC’s Donna Chan argues that for foreign corporates with both offshore and onshore entities engaged in trade settlement, there are options to hedge RMB and US$ flows in no less than five different RMB curves. Again, greater openness in the currency itself will eventually harmonise these markets, at least to a degree.

Another clear next step is the long-awaited mini-QFII scheme, which will allow Chinese securities and fund management companies to raise funds in Hong Kong and then invest them into China’s asset markets. Guidelines on this market have been expected for some time, and keenly so, as the method used for the scheme will have a major knock-on effect for asset management firms.

The backdrop to mini-QFII is that there is far more capital wanting to get in to China than is permitted to today through the existing QFII program, which is one reason H-shares have tended to be so expensive in Hong Kong. “There is a clear reason why Hong Kong assets are such a common substitute for the real thing: at US$20 billion, the mainland QFII program comes nowhere near meeting current foreign demand,” notes Z-Ben, a research consultancy on the asset management industry headquartered in Shanghai. “If supply and demand were balanced, there wouldn’t be 100+ foreign firms waiting patiently for their QFII application to be approved, nor a similarly long list of firms with applications outstanding for an increase in quota.”

Z-Ben expects mini-QFII to be open predominantly, if not entirely, to Chinese fund managers and securities companies having a base in Hong Kong. “Will that program create serious competitive threat to anyone, given that renminbi sitting in Hong Kong savings accounts, while growing quickly, total RMB400+ billion? Probably not,” says Z-Ben. But it contends that the future of mini-QFII will not just be CNH – RMB assets in Hong Kong – but CNY broadly and the ability for approved firms to apply for quota to convert foreign currency into RMB. That’s a very different proposition.

“Imagine China’s top half-dozen asset managers (and, if you want to frighten a colleague in the securities trade, its top half-dozen brokers) as the only government-endorsed domestic gatekeepers licensed to solicit foreign funds for investment in the mainland’s equity markets,” Z-Ben says. “Imagine them splitting a pilot pool of quota roughly equal to the QFII pot. Imagine their four-word marketing slogan, the one no global firm can equal: ‘Real China Access Here.’ Imagine the calls from clients who’ve just heard their first pitch from a mainland asset manager, asking if your firm has 500+ China equity researchers. Now imagine how much havoc Chinese managers will wreak on the Greater China sector, cutting fees, deals and corners as necessary to secure major global clients while they learn how to service them.”

Z-Ben is making a lot of assumptions in setting out this case, and at this stage we’re not even at the first phase of mini-QFII, but it’s true to say that the likely progress is being keenly debated among international (and local) asset managers.

In terms of capital market development, another area with plenty of progress to make is RMB IPOs. One has already happened: Hui Xian’s REIT at the end of April, which raised RMB10.48 billion for parent Cheung Kong. It wasn’t a deal that went especially well, and on top of that, it’s not exactly an equity listing but a real estate investment trust. “The features of a REIT are a mixture of bonds and equity,” says Freda Wong, executive director, corporate finance at CITIC Securities International. “They pay interest, so the regulators in Hong Kong and the PRC were more comfortable to launch it to test the market. We expect some more of these RMB REITs will follow, but a pure equity RMB product will take time.” It is hard to say when. “If it was just micro factors involved, like a deal, that is easy to handle. But there are many macro factors that need to be considered before an innovative product like this is launched. They need to see if liquidity is ready, trade settlement, brokers, intermediaries… there is a lot to do.”

Another next step in the market’s evolution is the development of further offshore centres for RMB. This is a hotly discussed subject in Singapore. “Singapore has to get themselves a central clearing line, otherwise they will just be a sub-centre to Hong Kong,” says Chia. “They are in the process of getting that. Once they’ve announced it, our interbank market can start making a price on CNH.” The Monetary Authority of Singapore does have a CNY swap line – the eighth foreign central bank to receive one – and when it did so, it received the third highest amount in absolute terms, and the highest in proportion to Singapore’s market share of China’s total trade in Asia; this was seen as demonstrating the importance China places on Singapore as a potential offshore centre. In due course, London and New York may become RMB centres in other timezones.

But these are all parts of the bigger picture of RMB internationalization. “We define the RMB internationalization process in three stages that chart its rise as a global trade settlement currency, a global investment currency, and a global reserve currency,” noted HSBC Greater China economist Donna Chan earlier this year. The first stage kicked off in 2009 and should hit critical mass by 2013-15, she says; the second launched in mid-2010 and will develop alongside the first. “The third will be a multi-decade process and won’t be possible without full RMB convertibility.” It’s at that third stage that the CNH and CNY currencies will converge again.

“Beijing’s ultimate aim is to keep the RMB rising as a global trading and investment currency, but at its own pace and in its own way,” concludes Chan. “Arbitrage activities make it difficult to track and control this process, blurring Chinese regulators’ windscreen. Only once RMB trade settlement channels have been adequately flushed and fitted with new filters will Beijing forge ahead with its longer term strategy for internationalizing the RMB. This, clearly, is already happening.”

But there’s another perspective people ought to bear in mind: that a freer currency doesn’t necessarily mean great news for those who are heavily invested in China itself. CLSA strategist Christopher Wood took on this topic in his closely-followed Greed & Fear research note in May, and suggested that China may soon intervene to cool the RMB offshore market. “The first reason for a cooling off is that the political leadership is fundamentally uncomfortable with an open capital account,” he says. “It must already be worried that the capital account is dangerously porous, in the sense that it has long been a practical reality that the wealthy and the connected can get their money out of China.” Wood doesn’t think real liberalization of the capital account is on its way any time soon, but he adds that if it happened, he “would become extremely cautious on the China story.”

Investors have been fervent in their appetite for Chinese-issued offshore RMB bonds. But in doing so, have they neglected due diligence, or even basic common sense? In an environment in which unrated issuers, who if rated would be well down the spectrum of high yield, are attracting multiple oversubscriptions for relatively low coupons, it is worth asking just how much risk investors are taking.

For one thing, there’s a big difference between buying the paper of a company that owns assets, and buying the paper of an offshore-issuing holding company that is linked to those assets. “In China, you’ve got an issue of structural subordination that arises,” says Matthew Sheridan, a partner at Sidley & Austin. “As a practical matter, it’s impossible to get guarantees from companies onshore for the offshore debt. An offshore holding company issues the notes, and they don’t have guarantees from the subsidiaries that own the operating assets in China.”

Lawyers are united on this. “When it comes to structuring, the first issue we often come across in China is the upstream guarantee or security issue,” says Joseph Tse at Allen & Overy. In many recent high yield bonds from PRC issuers, investors have wanted the issuers to provide security over assets in China. “Unfortunately, under Chinese foreign exchange regulation that is not possible,” says Tse. “To the extent that investors need security – and very often we see deals are not secured – they will have to settle for offshore security.” This means security over assets of the offshore holding companies, although “those assets typically just comprise shares in intermediate holding companies rather than hard assets.”

While these issues have long been problematic for dollar-denominated high yield issues from China, they are just the same for issues in RMB, if not worse. “Exactly the same issues in relation to taking of security arise whether the bond is denominated in RMB or not,” says Tse. “But with RMB bond issuance there is an extra layer of regulatory issues separate from the security issues, and the biggest of them is the repatriation of proceeds.”

It’s not as if investors are blind to this – or at least not all of them. “Investors are getting a huge premium in terms of the coupon on some of these issues,” says Sheridan. “There are some pretty savvy investors out there who think this is a great play.” But investors do seem to have decided that the merits of exposure to a rising currency with a decent yield outweigh the risk of losing everything in the case of a default.

“Investors have come to accept the fact that taking security in China is not straightforward at all,” says Augusto King, co-head of debt capital markets for Asia at RBS. It’s well understood that the vehicle they are buying does not hold assets, and that as a consequence the investors are going to be subordinate to onshore creditors. But, knowing this, they invest anyway. “With their eagerness to participate in the market, a lot of investors have gotten over this problem now. Instead they focus on how they should be paid for that structural subordination. But that problem – the ranking of offshore investors versus onshore creditors – is not going to go away.”

Opinion is divided on whether this is getting better or worse. On one hand, the experience of lawyers is telling. “In 2008, when the market fell apart, we thought China high yield would have to come back in a different form, and we started looking at structures to improve the situation,” says Sheridan. “But there is no silver bullet. There are structures you can put in place, but they have drawbacks and we couldn’t find enough interest on the bank side to take any of them to market, and then investor demand came back so there was no need to do it.”

That said, some bookrunners do report a shift in attitude in recent months. “In April, we saw a lot of credits without strong covenants issuing, because the asset side of the offshore RMB market is limited and there has been a grab for assets,” says Vishal Goenka, head of local currency credit trading for Asia at Deutsche Bank. “What has happened in the last few weeks is that some of the weaker credits have not seen the light of day. This is a marked difference from what has gone before. Investors are beginning to do some credit differentiation, and that is a good thing.”

While in some cases this differentiation will mean pulled deals, in others it just means more attention paid to covenant packages.  “In the past year, people were looking at CNH market deals with zero covenants,” says King. “But when we went out with corporate deals this year, investors said: can you put in some covenants, because we need to see some discipline. Now you’re already seeing that a lot of non-investment grade companies coming to the CNH market will have some covenants on the debt side, much like maintenance covenants.”

King doesn’t name the issuers he’s talking about, but it is understood that TPV Technology, which raised RMB500 million in three-year bonds in March, was an example of a Chinese issuer where potential investors said they needed to see covenants before being comfortable to invest.

Tse says covenant packages vary widely in the offshore RMB market. “In dim sum bonds, there could be a range from investment grade covenants to full high yield covenants, with a lot in between,” he says.  High yield covenant packages typically include restricted payment, debt incurrence, negative pledge, asset sales, transactions with affiliates and change of control. They sometimes extend to restrictions on mergers and consolidation, dividend payment, issuance of capital stock by restricted subsidiaries and others. “The covenant package will reflect the quality of the issuer,” Tse says.

Other bankers look to currency and rating issues. “The most important thing is the credit rating,” says Freda Wong, executive director, corporate finance at Citic Securities International. “Many of the privately-owned companies that are issuing bonds don’t have a credit rating, and some do not have a guarantee from the parent company. So credibility is a key point investors should pay attention to: Whether the issuer has the ability to honour interest repayments.”

And the ability to honour those payments isn’t just about creditworthiness: in situations where money must cross borders to service a bond, particularly in a controlled currency like the RMB, that adds another layer of uncertainty. “If they are issuing RMB bonds and will repay the principal or interest in RMB, then they need to remit RMB out of China to honour this obligation,” says Wong. “Has it conducted the right administrative procedures for RMB remittance? Normally that takes time.”

The question of the currency creates another set of risks, although the fact that the bonds are trading in one of the freest capital markets in the world makes it a curious situation.  “One investor risk that’s pretty clear cut is capital controls,” says Chia Woon Khien, managing director and head of local markets strategy for Emerging Asia at RBS. “If they impose capital controls in Thailand, your money can’t come out. But what’s the chance of Hong Kong imposing that? Next to nil. So you have an advantage there.”

But there’s also the fact that one is dealing in a controlled currency trading outside its home market. “The other side of it is that this is an offshore market, and the FX risk is greater in an offshore market than an onshore one,” says Chia. “The PBOC will intervene if necessary in the onshore debt market, but it’s not going to step into an offshore market to intervene. In the offshore market it will depend if the HKMA steps in – or the MAS, when Singapore issues bonds. It is up to the central bank in your jurisdiction where the bond is issued whether they want to intervene.

“Although in its physical form everything is CNY, the price of the currency is different between onshore and offshore,” Chia adds. “There could be an extreme event that creates uncertainty, and the offshore markets are subject to the reaction to whatever that event is. Onshore, you’re protected by a central bank; offshore, you’re on your own. So you have a bigger FX risk even though you might not see it now.”

Investors don’t yet seem to be going to third parties to insulate themselves against default risk. “In terms of buying actual protection, we’re not seeing anyone doing that,” says Xiang Hong, deputy head of global rates for Greater China at Deutsche Bank. “But it can be done: we have seen reinsurance companies covering political risks, and that could include China.”

It should be said that Chinese companies coming to market with less-than-watertight guarantees and covenants isn’t necessarily a sign of those companies seeking to hoodwink investors; there is, too, an evolution that needs to take place in the issuer base itself. “It [offshore RMB] is a good opportunity for Chinese issuers to go abroad,” says Tony Wong at Bank of China (Hong Kong).  “But there are several issues for Chinese issuers during this process – one is rating, another is corporate governance – before they are fully recognized by the international community.”

It’s not too hard to envisage a future when the RMB is a reserve currency to rival the dollar. It can’t happen now, of course: no currency that is not freely convertible could serve such a purpose, and while China’s current account is opening, its capital account remains very much closed. But if you assume the end-game is full convertibility, then it’s perfectly logical to see the RMB as another world currency.

“China now holds 30% of the world’s US$9 trillion foreign reserves,” says Woon Khien Chia at RBS. “The other 70% which does not belong to the People’s Republic of China could potentially be held in CNY. As China’s share of world trade matches that of the US, the demand created for CNY to settle exports and imports could potentially be as big as that for US dollars.”

As the RMB becomes more international, it’s also natural to wonder if it can become an alternative to the dollar in terms of debt capital markets fund-raising.

To an extent, one could argue it already is. Certainly the growth of the domestic RMB capital markets has been a game-changer for Chinese issuers. “China has become a significant financing market with a domestic bond market that didn’t kick off until the last few years and has quickly become the third-largest in the world,” says Eric Greenberg, managing director, financing group at Goldman Sachs. Another banker adds: “It’s an infant. It will become the largest market in the world once it’s grown into a toddler.” When the RMB becomes a more open and convertible currency, why shouldn’t that domestic market serve the same international purpose as the dollar capital markets do today?

For the moment, the swift growth of offshore RMB bond markets also demonstrates that the Chinese currency has become a useful funding source. One sees development of this market both for domestic and international issuers. “Real estate has obviously been a very significant component of overall issuance, and will continue to be because there is obviously significant demand for housing in a huge economy with a very large population,” says Rod Sykes at HSBC, speaking of Chinese debt market issuance generally. “But I do think we will see an increasing proportion of issuers not from that segment of the market. They may be industrials, manufacturers, retailers. In the RMB market, for instance, we’ve seen renewable energy and retail recently.”

And while the domestic issuer base has grown, RMB is already proving useful for a growing number of internationals, among them McDonald’s, Caterpillar, and lower-rated names like Galaxy Casinos and Russian bank VTB. Clearly, the volumes raised by issuers like these are limited so far, and in McDonald’s case predicated upon the need to have RMB available for expansion onshore. “Issuers that fund at 50bp or 60bp over Libor in the dollar market are not looking at CNH bonds as a source of arbitrage funding,” says Herman van den Wall Bake, head of global risk syndicate at Deutsche Bank. “They may pay around 130bp more, after the swap, than they would from a straight dollar bond. But if you have a real need for renminbi, it is lot cheaper to sell CNH bonds than it is to fund onshore.”In any event, it’s a start, and international issuance is only going to grow.

That growth will start with a steady maturing of the market, already underway. “We need to see a deepening of the offshore RMB market,” says Puay Yeong Goh, FX strategist at Credit Suisse. “We need the People’s Bank of China to continue allowing more CNH bonds so as to build a benchmark curve for the market.” As discussed in other chapters, the rate of growth of RMB deposits in Hong Kong makes for a ready market to digest these issues.

As that market deepens, there is likely to be an increased willingness for further FX liberalization. “The next step in the gradual opening of the capital account would probably be for the PBOC to start allowing offshore banks to put their money back into China, allowing the QFII status to be used for RMB rather than just converting foreign currencies into RMB,” Goh says. “That’s a gradual step, further down the road. The timeline is pretty difficult to call, but it’s going to be the medium term: two to three years.”

The true use of the RMB as an international currency on a dollar standard also requires a number of the idiosyncracies of the existing arrangement to unwind. These are the consequences of the limited opening of the currency with a closed capital account, which means – as explained elsewhere in this guide – that the same currency behaves in completely different ways onshore and offshore, and operates on three different forex curves. “As CNH deposits increase and liquidity improves, you should start to see a convergence of the NDF [non-deliverable forward] towards the [deliverable] CNH curve,” Goh says. “Right now the problem is that CNH liquidity is about one third of NDF liquidity, so there’s not enough force to push the market to converge. When liquidity in both curves is similar, you should see convergence; but the gap can continue to widen because of the controls in place. Until you see more opening of the capital account, it’s difficult to see convergence.”

While some bankers are loving the opportunities provided by this clear arbitrage, others are wary. “CNH doesn’t exist except in our heads,” says one very senior western banker, a country head in Asia. “We are all for helping China do what I think it means to do, which is to make the RMB an international currency of trade and settlement. But the arbitrage… I’m saying to our wealth management people, be very careful, because if all this unwinds, you’ve got nowhere to turn.”

On the trade settlement side, RMB is becoming more international by the day. The volume of international trade settlement conducted in RMB was RMB310 billion in the first quarter of 2011, according to the HKMA, which is close to the full year total for 2010, itself a vast increase in 2009. “There is a lot of room to grow,” says Goh. “For the next one to two years at least, this pace of growth should not slow down.” That growth – and not just in Hong Kong – is essential for greater application of RMB as a reserve or international capital markets currency. “It will eventually go to a reserve currency, but there are a lot of hurdles,” says Goh. “For it to be on a par with the dollar or even the euro, there needs to be much broader and deeper usage of the RMB beyond the central banks. It needs to be an international currency for trade settlement and financing,” which in turn means a fully open capital account, he says.

Still, the momentum is clearly in that direction. There is, for example, a lot of talk about including the RMB as a currency within the basket of special drawing rights (SDRs) run by the International Monetary Fund. French finance minister Christine Lagarde was vocal about this idea in the annual Davos meeting in January. “It is quite bizarre that the Chinese currency is not part of the basket underlining the SDR, because China is the second largest economic power of the world, and first for exports of goods and services,” she said then, in remarks that are particularly relevant since Lagarde is now quite likely to be the next head of the IMF itself. Since SDRs are, by definition, international foreign exchange reserve assets, inclusion in the basket would be a significant step towards internationalization.

So if we forward the clock, say, five years, and see a fully convertible RMB, what does that mean for capital markets? Well, it becomes an option to consider like any other currency: something to be weighed up along with interest rates of the time, calls on likely currency direction, the available maturities for fund-raising, and investor sentiment. Just as issuers weigh up the pros and cons of an issue in dollars, euros, sterling or yen today, in the near future they will simply add the RMB to the mix.