The Republic of Korea became the first foreign sovereign to raise money from China's domestic bond market on Tuesday, setting a key benchmark for the world's top borrowers as they mull the progressive opening up of an important new source of global funding.
The Rmb3 billion transaction, known as a panda bond, was highly symbolic on a number of levels.
For Korea it was clearly very important to become the first sovereign to access the market since the transaction has enabled the country to underline its extremely close geographical, cultural and economic ties with its much larger neighbour, now its largest trading partner.
For much of its history Korea was designated as a vassal state of China. This entailed making regular tributary offerings to successive emperors as a form of insurance against greater dominion.
The new three-year bond deal is a modern acknowledgement of that historical relationship known as feng gong (older/younger brother). As such, the Republic was understandably keen to leapfrog the Province of British Columbia to the head of the issuance queue after the latter publicly mandated Bank of China and HSBC for its own deal.
Bankers said Korea was able to successfully argue its case during a visit to Seoul by Chinese premier Li Keqiang at the end of October. This accelerated execution of its deal, which has priced flat or slight through the Chinese policy bank curve depending on which spot price investors used to benchmark it against.
For China, the transaction is equally important. It plants a new flag along the route towards a fully functioning domestic bond market that will help its banks meet the new Basel III capital rules and pave the way for a much greater international role for its currency.
Bankers believe progress is likely to accelerate on both fronts in 2016. The country is drafting new regulations covering panda bond issuance and the IMF's recent decision to include the renminbi in its basket of Special Drawing Rights (SDR) should progressively bring greater foreign investment into Rmb-denominated assets.
Tight pricing
In positioning its deal, the Republic decided to plump for the same three-year maturity adopted by Bank of China, HSBC and Standard Chartered, which have all issued panda bonds over the past two-and-a-half months.
The former two banks effectively re-opened the market after a 10-year hiatus with respective Rmb1 billion offerings at the end of September, which carried 3.5% coupons. Last week, Standard Chartered followed them with an Rmb1 billion issue, also priced at 3.5%.
The Republic of Korea's (RoK) deal carries a 3% coupon and was priced at par. At the time of pricing, China's sovereign (CGB) three-year paper was trading around the 2.78% level, according to syndicate bankers.
China Development Bank (CDB) was trading around the 2.98%-3.01% mark depending on which bank was quoting it. Other policy bank paper for the Export-Import Bank of China (Chexim) and Agricultural Development Bank of China was about 10bp to 15bp back of CDB.
"This was a very good outcome for Korea," said one syndicate banker. "When we started this process no-one thought it could come through CDB levels."
According to its offering circular, Korea is remitting proceeds out of the country for its Foreign Exchange Stabilization Fund. As such, bankers said it was meaningless to compare pricing on the panda bond deal to the 1.8% yields the Republic's three-year paper is trading at back home.
Initial guidance was pitched at 3%-3.5% and the leads are said to have built up an Rmb15 billion order book, enabling the deal to close five times oversubscribed. All of the paper was placed with domestic investors, with no foreign participation.
This distribution pattern reflects two important trends. Firstly, for domestic investors, the RoK paper offered diversification away from the policy banks, which dominate issuance in the domestic interbank market.
They may also have noted that, while Korea and China share the same domestic ratings on the mainland (AAA), they have different international ratings, in Korea’s favour.
Korea, for example, is rated Aa3/AA-/AA- and is on positive outlook from Moody's.
China, by contrast, has an Aa3/AA-/A+ rating. This means it is rated one notch lower by Fitch and is on stable outlook from all three agencies.
"China still has capital controls in place so when domestic commercial banks were offered a high quality asset like this, they just all piled in," one banker said. "None of the earlier panda bonds have traded much in the secondary market and this one isn't likely to either. It's a buy and hold asset for domestic accounts," the banker added.
Rmb depreciation
Foreign investors, on the other hand, have a much wider choice of assets to invest in, including the offshore Rmb, dim sum, or CNH market, as it is variously known. Ever since China devalued its currency in August, the offshore CNH market has been offering higher yields than the onshore CNY market on a like-for-like basis.
This has made foreign investors more cautious about diversifying further into the world's third largest bond market in terms of outstanding issuance.
At the end of 2014, foreign investors held 1.9% of the Rmb35.9 trillion domestic bond market according to HSBC research. At the end of this October, they were still holding 1.9% of an expanded Rmb40 trillion market, according to Bank of China figures.
Recent moves to increase foreign participation include a widening of the investor base in the interbank market to include foreign central banks, sovereign wealth funds and what the People’s Bank of China (PBOC) terms "global financial organisations". The country's RQFII and QFII quotas have also expanded rapidly this year, with the former rising from Rmb299 billion to Rmb419 billion and the latter to $79 billion.
The IMF's SDR move should also, over the longer-term, encourage much greater investment in Rmb-denominated assets as central banks match their FX reserves against China's weighting in world trade. China has been assigned a 10.92% SDR weighting.
In a joint report, published this April, the PBOC and HSBC forecast that central banks would hold 2.9% of their FX reserves in Rmb-denominated assets by the end of the year. This figure stands far below China's current 17% share of world trade. However, the two believe it will increase to 10% in 2025, a figure also in line with Barclays’ best-case scenario at that point.
But the big short-term deterrent to greater involvement is possible Rmb depreciation, which would more than counterbalance potential gains from spread tightening if China continues to loosen monetary policy. And bankers and analysts are unanimous in their belief that onshore policy bank yields will drop through 3% in 2016 as China loosens further.
Bankers said this was an additional factor spurring domestic investors to lock in yields now.
For while the US Federal Reserve seems set to embark on rate hikes, the PBOC is still heading in the opposite direction. Since the end of 2013, three-year CGB yields have progressively dropped from around the 4.4% mark.
In a recent research report Nomura argued that CDB's three-year yields could fall to the 2.25% to 2.5% level by the second half of 2016, while benchmark 10-year CDB yields could tighten in to 2.75%. The securities firm advocates investors buy onshore "bonds on an FX-hedged basis as our house view is that the Rmb will depreciate faster than FX forwards are currently pricing."
Banks and analysts also agree that the onshore curve is likely to steepen, with the short-end outperforming if government loosens policy and ongoing debt swaps by local government financing vehicles weigh on issuance at the longer-end.
Pipeline builds
For prospective issuers, on the other hand, the panda bond market offers a welcome new source of funding that should provide diversification benefits, be less correlated to other international bond markets and potentially bring down funding costs.
A pipeline of issuers is steadily building up including: Canada's Province of British Columbia, Russia's state-owned development bank Vnesheconombank, the Republic of Indonesia, Thailand's Siam Commercial Bank and the Export-Import Bank of Kexim (Kexim).
Indeed, one of the chief purposes of the Korean sovereign deal was to set a benchmark for other issuers from the Republic. “This landmark issue has not only set a precedent for sovereigns seeking to diversify their funding alternatives, it could also serve as a benchmark for Korean corporates and financial institutions,” said DJ Kim, CEO of HSBC Securities Korea.
Haitong Securities recently estimated that annual panda bond issuance could top $50 billion within the next few years. Ashish Malhotra, Standard Chartered’s global head of bond syndicate, told FinanceAsia the market’s development represents the “most exciting event in Asian capital markets history.”
Some $50 billion of issuance per year is also not an unreasonable sum given that 157 issuers raised $33.3 billion from the dim sum market during 2014 according to Dealogic figures. So far this year, 199 issuers have raised a far lesser $17.3 billion.
Duncan Phillips, Citi's head of Asian debt syndicate said the bank “expects to see further issuance across several sectors including sovereign, bank and corporate issuers as the market develops further."
Revised guidelines
How quickly this unfolds will depend on the outcome of new guidelines currently being drafted in China. "Until we see the draft it's hard to predict how quickly the market might grow," one banker concluded. "There's a lot of interest but at the same time there's going to be a long lead time as international issuers get comfortable with a market that's subject to PRC law and documented in the Chinese language."
The most recent crop of issuers have all had to tinker with a format, which was originally designed for multi-lateral agencies such as the Asian Development Bank (ADB) and IFC back in the mid-noughties and was amended again in 2010.
The domestic market differs from international markets in a number of respects, including T+1 settlement compared to T+3 settlement, as well as the payment of annual rather than semi-annual coupons.
In a recent research report, Bank of China described the current panda bond regulations as "quite restrictive." For public offerings, issuers are required to prepare financial reports under China's accounting rules and secure a minimum of two ratings, one of which must be a domestic rating.
German car company Daimler circuited this process in 2014 by issuing via a private placement. However, bankers said this is not going to be favoured option for many borrowers since private placements generally require more of a yield kicker.
Bank of China also added that a clearly defined set of rules also needs to stipulate how and when borrowers can remit funds back out of the country.
Joint lead underwriters for the RoK's panda issue were BoCom, Citi, Goldman Sachs Gao Hua Securities, HBSC and Standard Chartered.
