IFR Asia RMB Bonds Roundtable 2017: Part 2

IFR ASIA: What’s behind this move, then? The regulators seem to be welcoming more international standards in the domestic market. Is that right?

RICCO ZHANG, ICMA: With Bond Connect in place, definitely there’s demand for rating services from the international side. If you compare, for example, a Panda bond and Dim Sum bond, the rating is just very different.

There are two reasons behind the make-up of the domestic ratings industry. One is just as Philip mentioned: it’s a domestic market. The biggest investors in the onshore market are actually banks, not asset managers. They are only allowed to invest in high-rated products, so if it’s not high-rated there’s no product at all. That’s why you see a lot of Triple A, Double A ratings.

IFR ASIA: Well that’s a little bit backwards though isn’t it? That rule should stop them from buying riskier assets, not inflate ratings.

RICCO ZHANG, ICMA: This is exactly the second point I want to make. When you’re talking issuers whose underlying assets are all in China, it’s very difficult for overseas investors or regulators to get their hands on those assets.

In China, it’s very easy for domestic creditors to get control of those assets, so that backs up the rating. The big Chinese rating agencies and the big three international rating agencies are all members of ICMA, and we’ve noticed two things from our discussions. One is there’s definitely a demand for international ratings services because the international community just trusts the international agencies more.

Second is that Chinese rating agencies are going to develop different criteria. Right now the domestic rating regime is more important for issuers looking to sell bonds. But for those wanting to attract international investors through Bond Connect, QFII/RQFII, etc, they’re going to want to give an international reference as well. So this is the approach the Chinese rating agencies are working on right now.

FREDDY WONG, FIDELITY: Philip actually brought up a very good point about the current dynamic in the onshore market. A lot of those issuers rated below Double A actually can’t price bonds in the domestic market right now. From a forward-looking perspective, China could do well to open that segment of the market, allowing lower-quality issuers to price their credit efficiently.

For historical reasons, a lot of the issuers in China are SOEs or government entities, so they are all close to the ceiling of AAA or AA+. But for a more efficient market, like anywhere else in the world, you want to allow the issuer lower down the credit curve to be able to price their credit efficiently. If the price is right, they would also have investors coming in to buy those credits.

Right now, just because the credit curve has been so flat, a lot of the pricing efficiencies may not apply to that segment of the market. I’m not saying that you need to just open up and bring in more low-rated issuers, but if you compare it with the global market, China needs to develop the right covenant package and investor protections. The regulators are actually doing a lot to develop that segment of the market.

So together with encouraging more global rating agencies coming to rate that credit, I think the long-term prospects for that segment of the market would be quite significant in attracting more international capital.

IFR ASIA: So it could actually be the international investors who are taking more credit risk?

FREDDY WONG, FIDELITY: I think it will be both sides. The domestic investors are actually very sophisticated at looking into the credit themselves, because a lot of the issuers are now lower rated, due to downgrades or worsening credit quality. But a good, fast-growing company with a domestic AA– rating and willing to pay even a double digit yield still cannot access the capital market. So they still rely on the banks to get their funding.

PHILIP LI, CHENGXIN: I think the Chinese capital markets will develop further and faster if the government is less involved. For example, before the default of Chaori Solar in early 2014, there was no bond default in China, but it doesn’t mean that no issuers had run into troubles – no debt default case was due to bail out actions by the government or the government-owned banks when the issuers were at the edge of default.

Now the number of default cases has increased. Last year, 70 issues actually defaulted, but it is relatively small when compared with the 25,000 outstanding bonds at the end of last year. It represents a default rate of 0.28%. This year 19 issues have defaulted. One reason is that, as Ricco mentioned, many issues are backed up by collateral, and most of the unsecured debts are issued by government-owned enterprises and very big issuers.

IFR ASIA: As more of the onshore bonds make it into global indices, then internationl investors are going to have to be comfortable with a lot of these risks, aren’t they?

KELLY MCKENNEY, TRADEWEB: Well first of all the major index inclusion will be government bonds only – whether it’s the FTSE World Government Bond Index, formerly the Citi index, or the Bloomberg Barclays global aggregate. The talk is that 5% of the WGBI index will be China bonds, and it’s a similar story for the Barclays index. Both of those have about US$2trn in total tracked assets.

Then you’ve got the JP Morgan emerging index, which is a much smaller index at around US$250bn but it’s like a 10% weighting, I think, for China bonds. Once again, I mean these indices all track government securities, so the expectation is that any increased allocation will go into the government market.

That being said, investors obviously need to be somewhat diversified. I know for a fact that Bond Connect isn’t just about access to the China government market – it’s covering all of the assets that would be available currently in the interbank market, or CIBM. So we expect that there will be investments in corporate bonds. We know for a fact there’s going to be a fair bit of interest in NCDs, so short-dated paper. There are some attractive yields there, so I think that’s certainly going to attract some of the foreign investors, regardless of what index inclusion says.

I think that’s relevant when you’re talking about investors taking the next step, with a portfolio manager onshore who really understands the market. The investors that are going to be onboarding Bond Connect for index trackers might not have as much expertise.

IFR ASIA: Freddy, what do you look to as a benchmark? Is it a domestic index that you try to beat or is there something global?

FREDDY WONG, FIDELITY: At this stage, clearly global investors are still allocating relatively small portions to the domestic market. By Philip’s numbers only 2% of the domestic market is owned by foreign investors, and they are checking, predominantly, the indices we’ve been talking about – the Barclays and JP Morgan and the Citi WGBI. But domestically there are a wide range of indices that domestic investors have been checking, ranging from just purely money-market type of index all the way to long-term credit. There are different baskets of maturities, too. Even though it’s a government index it could be a short or long duration product.

There is a full range of indices, domestically, with different characteristics – like our global market. I think it will gradually change over time to reflect what the global investor looks at, because right now a lot of those domestic indices are multi-asset, from a global perspective. International investors may want to allocate a certain portion of their global strategies into China, so that may change some of the domestic indices over time.

Clearly, the use of indices is quite a promising development for the benefit, if it can offer domestic and global investors different strategies.

IFR ASIA: So right now is the main driver the currency? There has been a nice bump in the RMB, for anyone who has already invested.

FREDDY WONG, FIDELITY: For the last few years we’ve seen a net capital outflow from China, but this year the bond market itself has seen net inflows every month. It’s about currency expectations as well as the interest rate differential on the Chinese government bond. The 10 year is still trading at 3.6% versus US Treasury yield at 2.2%–2.3%, and the currency has been depreciating for quite some time. So right now you’re seeing the currency start to adjust. China is not just looking at one single currency pair, they look at a basket, and to that extent the currency has been quite stable.

I would say that investors have been gradually putting more money into the domestic market, and the opening of Bond Connect came at just the right time. That gave investors a more flexible, more efficient and simpler way to go in. One thing to highlight for the development of the market in the future is to open up the bond futures market, because if you have index inclusion, a lot of the global investors could be benchmarked. If they want to adjust their duration, they may need an liquid and efficient futures market. In China the five and 10-years government bond futures are very liquid, comparable to what the US Treasury market looks like. But at this stage offshore investors cannot use the futures.

That just means that China could continue to open up in more ways. We could see the domestic futures market used by global investors. The Hong Kong Exchange actually did launch a China government futures product, but they will be closing it. This market doesn’t need to be split in two, in reality.

IFR ASIA: Where does this leave the offshore RMB markets? The five-year onshore yield is something like 3.6% you said, offshore it’s almost 3.9%. There’s still a big gap there. And Bond Connect only works for investors going into China, not outbound.

TIMOTHY YIP, HSBC: I think the offshore RMB market would still continue as normal, just like the comparisons between the domestic US dollar market and Eurodollar or offshore US dollar.

IFR ASIA: Yes, but in that case the yields are essentially the same, right?

TIMOTHY YIP, HSBC: Sometimes when people go and issue an SEC-registered bond they can get a lower cost of funding, but then the yields could converge over time.

From an issuer or investment perspective, it really depends on documentation and the method of issuance. Because ultimately if you’re doing a domestic deal – e.g. an onshore Panda bond – then you would need Chinese law and Chinese documentation. As for the offshore market, the attraction will always be the convenience. It could just be a drawdown of an MTN or GMTN programme. For Panda bonds, the regulators are, so far, approving on a case-by-case basis hence sometimes it could be challenging to have a precise timetable for such financing exercises.

That’s why multinationals or frequent issuers such as Libor-based financial institutions, for example, can just do their opportunistic drive-by transactions in the offshore RMB market. A sophisticated global issuer will look at funding both onshore and offshore and see what works for them. Obviously, they need to accept that the onshore financing option would be a longer-term project, whereas for offshore it would probably just be pressing a button.

IFR ASIA: Are there still investors who will buy offshore RMB?

TIMOTHY YIP, HSBC: It depends on the yields. The cross-currency swap has been more elevated in recent weeks, so that’s why recent offshore RMB bond issuers were able to offer an attractive headline yield for its recent transaction. And that’s why investors thought it was a very good deal. If the CCS kept on climbing to above 450/453, potentially you could have some Double A rated issuers looking for opportunistic arbitrage funding from a three-year tenor with a mid to high 4% yield. That would be quite attractive for investors compared to some of the onshore Panda bond options.

FREDDY WONG, FIDELITY: When the Dim Sum market opened up, at the very beginning, issuers could get very favourable pricing – much, much lower than we are talking about today. At that time the expectation of RMB appreciation was pulling capital into the market, and the RMB deposit base in Hong Kong was growing quite dramatically.

Capital flows like water. Whenever issuers find a cheaper venue, they would just for that – whether it’s a euro, US dollar, yen or RMB. At this stage Dim Sum’s probably not the cheapest venue for them, so many would rather hold back unless the currency swap makes it cheaper.

I will say Dim Sum will continue to grow, but it will take time to evolve. Over time, we’re talking about the same market. If you hold a US$100 note, you could go onshore or offshore and buy the same bonds using the same note. These two markets ultimately will be one single market, but how it transforms from two into one will mean a lot of work needs to be done in terms of hedging, and where the capital can flow freely between the two.

RICCO ZHANG, ICMA: Yes, that’s a big step for the real RMB internalisation as well. One thing I would say is that the Dim Sum bond market will still survive. One reason is because the Hong Kong market provides all the transparency and certainty that international market participants value.

As our colleagues at the table have mentioned, it’s the appetite from the investor base that has changed. From an international perspective, people still expect the RMB to depreciate over the next three or five years. Right now, the Chinese authorities want to control the capital outflows and most of the Dim Sum issuers, particularly in the corporate sector, this year are the major Chinese issuers. Basically the regulators have put a lot of hurdles up for onshore borrowers going out to tap the international market. So right now it’s more about the regulatory hurdles more than the currency part of it.

IFR ASIA: How does the Belt and Road initiative fit in with this market, and the internationalisation story?

TIMOTHY YIP, HSBC: The Belt and Road story is a national objective as exemplified by the Belt and Road summit in Beijing earlier this year, where lots of global leaders attended. It’s a natural extension for countries on the Belt and Road route to take advantage of this because ultimately their countries need investment in infrastructure. If the Chinese capital market is open to them, then why not use it?

If China’s opening its doors to a specific category of issuers, then we would recommend issuers to take advantage of that because it’s the right thing to do. And I think in a way the approval process could be more straightforward if it’s in line with the national agenda.

IFR ASIA: Are we going to get to a point where specific infrastructure projects are financed in the onshore RMB markets? Is that where Belt and Road is going?

TIMOTHY YIP, HSBC: I think that’s highly possible, because China is the world’s third-largest bond market and what the Chinese government has always been trying to encourage to do is to diversify Chinese investors away from Chinese credits, as a way of lessening the systemic risk in the system. That’s why we’ve got Panda bonds, that’s why we’ve got two onshore markets – the interbank and exchange market – trying to attract real foreign investors and issuers.

We will get countries from Eastern Europe, for example, Poland and Hungary, alongside others from Central Asia, Southeast Asia, etc. I think it can only be a good thing. The caveat to that is it must be done in a very carefully controlled manner in the way that we start with the highest credit in the spectrum – ie, the sovereigns themselves – and hopefully then the second tier would be some of the government-related entities and then thirdly, potentially, are corporates or financial institutions from those areas. And that’s what we’re seeing with Eastern Europe at the moment, with Poland and Hungary.

IFR ASIA: Do we get to a point where it ends up being called something else. Would a Belt and Road bond look any different from a Panda bond? You could end up financing projects in Pakistan through Hong Kong, or somewhere else, but maybe not in the classic Panda format, say.

RICCO ZHANG, ICMA: Well obviously the Chinese market is the biggest one and it’s the intention of the Chinese government to push the agenda. So Panda bonds are naturally the first choice for those railroad projects. Having said that, yes, you are right: Hong Kong, Singapore and the more developed capital markets in Asia are also open to those issuers as well.

It’s good to label such products as Silk Road bonds or whatever to give investors more confidence. On the other hand, it may be a little confusing. We have like a Panda, Green, Belt and Road – it’s just too many. People may be confused, what exact products are they investing in?

Last year China Construction Bank, Bank of China issued Belt and Road bonds to send a message that they support the initiative. One more important thing is that the infrastructure projects are not easy to evaluate. First of all the rating is very important. Second is that the involvement from the multilateral development banks through credit enhancement or a guarantee. We think risk allocation here will be very important, because it’s not fair for the capital markets investor to bear all the risks. So that requires more transparency – you need to define all the risks within the projects so as to decide which risks belong to which stakeholders. Maybe it’s a local government, maybe this part should stay with the issuer, maybe it’s the multilateral banks who can give some credit enhancement. Then we can give the right credit and the yield for the investor to get really their money into those infrastructure projects. Generally that’s how it should work.

PHILIP LI, CHENGXIN: It’s already more than one and a half years since the relaxation of the Panda bond market. Frankly speaking, from the strict definition of a Panda bond, many of them are not true foreign issuers. They are Chinese banks and companies that have established subsidiaries outside of China, then they come back to China to issue Panda bonds.

For the Belt and Road initiative, I have come across quite a number of potential foreign banks and corporations from Eastern Europe and Central Asia asking us how they can issue debts in the Panda bond market. They find it very difficult to meet the requirements and remit the proceeds out from China.

Although the door of the Chinese debt market is opening further, it will take time for the regulators to feel more comfortable with the inflow and outflow of funds of foreign issuers without disturbing the Chinese financial markets.

RICCO ZHANG, ICMA: For Panda bonds I think regulators are managing a very careful balance. We know that China is very cautious when pushing some reform, so obviously sovereign issuers are the first choice when they want to open the market. The default risk is very low, so the regulators welcome such issuers. But on the other side, they know that these issuers are going to take the money out of China, which is not the essential purpose of the Panda market, which actually is designed to let the issuers use the money in China.

There are still some things the regulators need to think through. I’ll give you two examples. Panda bonds are essentially for foreign issuers. But we all know that any participant in the Chinese interbank bond market needs to be a member of NAFMII. And to be a member of NAFMII you need to be a Chinese-incorporated entity – which is obviously not an international issuer. We should be patient to allow regulators to make such adjustments. The second thing is we still don’t have Panda bond rules yet. When we did a survey with international issuers, a couple of them mentioned that it’s not transparent at all. There are no rules, but the Chinese government is willing to consider such issuance under the existing rules. Some international issuers just don’t buy this kind of approach, so again there’s a gap between the two.

There’s still a lot of work to do. For infrastructure financing, again there’s a very big mismatch. Infrastructure products are very long-term products, so usually the investors are pension funds and insurance companies. But they are very concerned about credit ratings, and usually most infrastructure products don’t have a rating at all. So how should it work? One scenario is for some Chinese contractor to tap the market and give the financing indirectly to those infrastructure projects. A second option is for the overseas issuers to tap the Panda bond market and feed money into those infrastructure projects. Right now we’ve seen two different indirect ways to support these infrastructure projects.

IFR ASIA: I have a technical question for Tim and Kelly. I’m just wondering how offshore investors would buy Maybank’s Panda bond through Bond Connect. Can you tell us a bit about the difference about the onshore offshore bookbuilding process? And how do offshore investors trade onshore bonds through this scheme? Do they just need to open an account on Tradeweb?

KELLY MCKENNEY, TRADEWEB: That’s many questions actually! So if an investor wants to include a new issue in their Bond Connect portfolio, it’s actually a different settlement process than their onshore CIBM or RQFII investments. Bond Connect has a nominee structure, so that investment sits in a different location. Currently, the way they would access that is to go through the bookrunners, and work with the syndicate desks at the bank through which they’ll be buying that security. They don’t actually subscribe to a new issue through the electronic channels right now. While it’s something that we’ll be talking about as a future enhancement, currently they would go to the syndicate group, speak with their sales coverage contact, and purchase that bond. Once they hold that bond, it’ll be in their Bond Connect portfolio. As soon as that bond settles in the primary market, all of its codes are generated and it will be simultaneously available for trading on Bond Connect, and in the secondary market on CIBM. Tradeweb, as the international access point, we register that bond in our system, so that an investor is able to then bring up that security as a tradable bond.

How does an investor go about being able to trade that through Bond Connect? Bond Connect Company Limited looks after the onboarding process. It’s a joint venture between CFETS and Hong Kong Exchange, about 60/40. An investor wanting to trade through Bond Connect has to apply for each of the portfolios that they’ll be trading on behalf of. This is the same as if they were accessing CIBM, RQFII or QFII. They’d have to apply to be able to access that market for their funds.

So they make that request or they fill in the paperwork through Bond Connect Company Limited. I think BCCL now is talking about a two-week turnaround, because once that paperwork goes in, it has to be approved by the PBoC and then their Bond Connect access is set up. For the Tradeweb part of it, they just need to onboard as a Tradeweb client and connect to Bond Connect via Tradeweb, and we do linkages directly with CFETS to allow them to execute that security.

So for instance, if an investor decided today to buy the Hungary Panda bond in the primary market, they would speak to their banker. If they haven’t set themselves up yet to be accessing Bond Connect, then I think that it would be a little bit too short a time period. But that’s as you would expect for any other access scheme – you have to set up access before you start trading the securities. You need to get the account set up first, and that’s what most investors are doing.

TIMOTHY YIP, HSBC: The bookbuilding point is a very good question, where we spend a lot of time educating foreign investors and issuers. When we talk about public bookbuilding, we’re really talking about the offshore market. The onshore market really operates as a modified Dutch auction and that’s why the day before a formal book building at T-1, the issuer would put out formal price guidance. That is usually quite a big range, because ultimately people would be asked to submit their bids at that pricing range. So it’s quite customary to see ranges as big as 25bp–50bp from some of the top tier high-grade names to about 100bp or even 200bp for some of the more high-yield names.

Then, during the morning, investors would be bidding at the tight end, middle or higher end of that range, and then ultimately the market clearing price would be set at the point where the entire issue size has been allocated. The issuer, in effect has limited ability on allocations under the “price-first”, “time-first” principles, which is very much unlike the offshore market where the issuer would discuss with the syndicate members whether to let’s say revise price guidance – which Freddy hates – or in extreme circumstances widen price guidance or play around with the issue size.

In China at this stage of market development, everything has to be quite carefully structured. Investors need to know the parameters surrounding the tenor, the issue size as well as the pricing range. So once there’s been a formal deal announcement, unless there has been a force majeure event, for example, then the issuer would be committed to printing what they have said they would print. Therefore a Rmb2bn announcement would be a Rmb2bn transaction and the clearing price would be once all the lowest bids add up to Rmb2bn.

So everybody who puts in bids below that market clearing price would be fully allocated and then the issuer, potentially, will have some room for negotiation for orders at the margin.

IFR ASIA: Do the offshore investors through Bond Connect have any say on pricing?

TIMOTHY YIP, HSBC: Well they try to ask questions in different ways about where is the market clearing price and of course there are strict rules about disclosure there, because every investor onshore and offshore must be treated on an equal footing. As an illustration, domestic investors may be placing their bids at the middle to high end whereas the foreign investors just want to get on with it and say, “I want these bonds and therefore I am putting it at the tight range.” So there’s a lot of auction psychology in play!

IFR ASIA: So Bond Connect help issuers get a tighter price, effectively?

TIMOTHY YIP, HSBC: Definitely, yes, because foreign investors, as a result of higher familiarity with the Panda bond credit to the extent of already being holders of bonds in other currencies, could be more inclined to submit orders at the lower or the middle of the range.

RICCO ZHANG, ICMA: I would like to bring your attention to our work as well. I already mentioned our market comparison study together with NAFMII about international and domestic market practice. We identified three main areas of differences: disclosure, bookbuilding and due diligence. HSBC actually is one of the members within that working group. That’s something we prepared for the Panda bonds to take off in 2015, then we moved to Green bonds last year, and just this month we published a Panda bond report, again with NAFMII. I can tell you that probably we will work next on credit ratings. So if you follow ICMA’s work closely you can see the regulators’ priority.

IFR ASIA: Ladies and gentlemen, thank you very much for your time.