In September 2015, the People’s Bank of China further opened up its onshore RMB bond (Panda bonds) market by approving two foreign commercial banks to sell Panda bonds. This is an important move that heralds the development of RMB bond markets. On the offshore RMB bond (Dim Sum bonds) markets, China’s “One Belt, One Road” infrastructure development plan is expected to beef up demand for Dim Sum bonds, offering compelling opportunities for investors who want to tap into the growing bond markets in China.
Beijing has never previously let a foreign commercial bank sell Panda bonds in its rapidly growing, but largely closed, market which, at US$6.8 trillion, is the world’s third-largest behind those of the US. and Japan [1] It has let in only a few foreign borrowers, including the Asian Development Bank. As China’s economy is expected to grow at a steady pace, we expect to see stronger demand for capital from the bond market to finance its economic growth, leading to further opening of the domestic bond market for more foreign private investors and without quota limits.
Benchmarking effect to enhance onshore RMB bonds
Currently, foreign investors account for about 2% of the onshore RMB bond market [2]. The low participation of foreign investors is mainly due to that fact that the capital account of China is not yet open. As this account opens, we expect more foreign investors to be allowed to invest in the onshore RMB bond market. The Chinese authorities have recently opened up this market for foreign central banks and sovereign wealth funds to invest without quota limitations and we expect the said authorities to expand or even remove investment quotas for non-sovereign foreign investors. The other two markets, the offshore RMB and China USD bond markets, are fully open to foreign investors.
As China opens up onshore RMB bond markets, major international bond indices will have to include these Panda bonds in their indices. Global bond fund managers, who need to invest with reference to international bond indices, are very likely to expand their allocation to Panda bonds. In most emerging and developed markets, 20-40% of domestic bond markets are usually owned by foreign investors. Even taking a conservative estimate of a 10% increase, it will not be surprising to see that ownership of onshore RMB bonds by foreign investors may increase from 2% to 12%, equivalent to about US$680 billion of inflows to the market. Such opening up of onshore RMB bond market serves the purpose of RMB as an investment currency. At Invesco, we see plenty of value in RMB bonds which investors cannot afford to miss.
A stronger currency with attractive yields
Investing in RMB bonds can help investors to enjoy the best of both worlds. Firstly, RMB bonds offer higher yields than many counterparts in developed markets (Figure 1). Secondly, the RMB has been strong in the past few years, though not as strong against the US dollar for the time being. In recent years, the currency has appreciated significantly against the euro, pound sterling and the Japanese yen, as well as the Australian and Canadian dollars. Additionally, as the RMB tends to have lower correlations with other major currencies, including RMB bonds in an international bond portfolio, this will give investors the benefits of diversification.
China’s transition to consumption-led economy
As China’s economy is in transition to consumption-led growth, we see property bond issuers offering opportunities in both onshore and offshore bond markets. Property is set to benefit from the growth in the service sector, which is now larger than the output of the manufacturing sector. The service sector is now growing at 8.6% year-on-year, much higher than gross domestic product growth of 6.9%. In addition, property sales have been up some 20% year-on-year, which brings us to believe that certain property bonds are good to invest in, by riding on the consumption boom in China. Infrastructure is another theme for development of RMB bonds. China’s “One Belt, One Road” plan - the infrastructure projects connecting China and it’s neighboring countries, is expected to significantly boost the trade volume of South East Asian countries with China. We expect to see an increase of issuances in Dim Sum bonds to finance the “One Belt, One Road” infrastructure projects as these countries work with China, to match with the revenues in RMB. This will lay a strong foundation for the future development of the Dim Sum bond markets.
Dim Sum bonds more attractive than Panda bonds
We expect the central bank of China to continue to ease monetary policy to combat disinflationary pressures. While the recent respite in volatility is welcome, the structural challenges in China remain and will likely continue to exert deflationary pressures. We also expect onshore government bond (CGB) yields to move lower in this disinflationary environment. Despite the volatile aftermath of the recent shift in the foreign exchange regime away from a fixed rate regime towards a managed float, domestic liquidity conditions remain adequate. However, we are carefully watching for signs of capital outflow pressures re-emerging. We believe that China’s bond markets, together with Asian bonds, may be less linked with US interest rates in the future. As the trades with China become much closer than the US, Asian currencies may become a RMB bloc, making the impact of interest rates from China play a more important role.
Yields on offshore RMB bonds are higher than those on onshore given the same maturities and profiles. Credit risks in offshore RMB bonds (Dim Sum) have been fully reflected, but not into the onshore RMB bonds (Panda bonds), which are now trading at expensive levels, given the current levels of credit spreads. Within the Panda bond markets, we prefer RMB bonds issued by government and policy banks. In the offshore arena, we prefer corporate bonds. Offshore RMB bonds are more attractive than onshore ones as the offshore yields are generally higher for similar maturities and credit profiles. Expecting the offshore RMB bond yields to decline on the back of off-and-on-shore yield convergence, we will actively look for opportunities to buy bonds of longer maturities so as to lock in higher interest rates for longer periods. We expect that yields on onshore and offshore will converge, similar to the case of domestic US dollar bonds and Euro-dollar bonds (offshore).
Holistic approach to investing in RMB bonds
Some investors are concerned about the differences in credit ratings between international and local Chinese agencies. The differences are largely due to the different practices and perceptions of risk. We see such difference reflected in the yield differential for the same bond issue, with offshore and onshore bonds of the same maturity, by the same issuer, having different yields. We see such discrepancies as investment opportunities because we have a deep understanding in offshore and onshore markets and in local and international practices of credit rating.
When it comes to investing in RMB bonds, a holistic approach is the key. From our observation, Chinese investors usually only focus on onshore RMB bonds, while Western investors may only focus on the Chinese US dollar bond market and Hong Kong investors may only focus on offshore RMB bonds. To get the most out of the RMB bond markets, we have to compare relative value across the three markets for a given issuer. In the short run, these markets will tend to diverge due to the different investment behaviors of the different investor bases. As China opens up its capital account, we believe the yields of these three markets will tend to converge over time.
[1] Source: The Wall Street Journal, 23 September 2015
[2] HSBC, “The RMB Credit Primer,” March 2015.
Source: Bloomberg, HSBC, Bank of America Merrill Lynch, Invesco, at 30 Sep 2015. Represented by HSBC Offshore RMB High Yield & Non-Rated Bond Index, average duration = 1.9 years as of 30 Sep 2015.
The author is Ken Hu who joined lnvesco in April 2014 as CIO, Fixed Income, Asia Pacific. A fixed income senior investment professional, Ken acts as the company's primary liaison in Asia Pacific, and leads overall fixed income efforts in the region including growing its fixed income presence there and overseeing fixed income investment products and processes.
