Dim-Sum Bonds Difficult to Digest

The unwritten promise embedded in the Hong Kong market for yuan-denominated bonds is that low yields will be offset by the steady upward march of the Chinese currency. Now that the promise seems broken, investors are finding the bonds—referred to as dim-sum—more difficult to swallow.



In the first half of the year, the continued rise of the yuan appeared inevitable. But a combination of China's weak export growth, diminished domestic inflation and a stronger U.S. dollar have taken the edge off expectations the currency will strengthen significantly.
[CHINAHERD]

Data on China's current account, released Tuesday, bolster Beijing's argument that the yuan is close to fair value. The surplus for the first three quarters of the year came in at 3% of gross domestic product, down from 5.1% in the same period in 2010. Importantly, the surplus is below the 4% threshold proposed by the U.S. as the baseline for assessing currency misalignment.

The nondeliverable-forward market is pricing in close to zero appreciation of the yuan against the dollar in the year ahead. NDF markets are often too pessimistic, but certainly a slowdown in yuan appreciation from around 5% in 2011 to something more like 3% in 2012 seems likely.

With less to gain from movement in the exchange rate, investors are already demanding higher yields on their dim-sum bonds. Chinese government bonds issued in Hong Kong this August with a 0.6% coupon are now trading at a yield of around 1.5%.

Another factor that might push up yields: alternative options for investing in yuan-denominated debt. The government of Hunan province in south-central China is reportedly seeking a 10 billion yuan ($1.58 billion) syndicated loan in the Hong Kong market. Patrick Law, head of trading for Greater China at Barclays Capital, says more competition for offshore yuan means there will be increased pressure for issuers in the dim sum market to offer higher yields.

Excess liquidity should put a cap on how far yields rise —there is 622 billion yuan in deposits sitting in Hong Kong's banks, compared with around 190 billion yuan in outstanding bonds.

But the evidence suggests that expectations about China's currency are still driving the market. The Bank of China Hong Kong offshore yuan bond index is down 6.5% since its June high, the same period over which hopes for yuan appreciation have faded.

Long term, the yuan's rise against the dollar still seems like a good bet. But dim sum bonds are no longer perceived as a sure-fire winner from appreciation. As more nuanced expectations on the exchange rate develop, investors will surely develop a more discerning appetite for dim sum.

Source: http://online.wsj.com/article/SB10001424052970203699404577041572665925312.html?mod=WSJASIA_hps_sections_china