Investing in CNH? The onshore market could be where the real action is

By:
Hamish Risk
Published on:

Last week a mainland Chinese delegation held a presentation at the offices of Bloomberg here in London to promote the opportunities of investing directly into China’s onshore bond market.

By all accounts according to some investors that attended the presentation, it was both professional and compelling. The essential message was that if you were a serious investor, and you want to get involved in China, onshore bonds are where the real market is.

They explained the offering, which included a comprehensive suite of investor services ranging from custody, valuation, accounting and a market structure that was easy to understand, say the investors. All that the investors needed to do was to register as qualified foreign investors, or QFII status.

What was the real eye opener to the investors was that this was a message quite different from that of the proponents of the CNH Dim Sum bond market, which presented itself as a surrogate offshore market that gave investors’ exposure to China, and was essentially unregulated.

Much of the optimism about a surge in issuance of Dim Sum bonds in 2012 has started to wane. Bloomberg data shows that issuance so far this year was Rmb143.3 billion year-to-date versus 152 billion for all of 2011, hardly a great result for a burgeoning bond market that has been given so much promotion.

Issuance is down nearly 50% this month versus last month, and while it is true that tight liquidity in Hong Kong is making issuance difficult, it is also a case that it is a result of yield compression versus the onshore rate is making it a less attractive destination for investors.

This is where it gets interesting say some investors. If China’s onshore bond market is really that accessible as the officials last week stated – and why would they be in London pitching to investors if it were not – what does that mean for the development of the Dim Sum bond market?

"I strongly suspect that once people realise that as a foreigner you can trade the underlying market without too much of difficulty, the offshore market is going to be left as peripheral market, "says one of the investors who attended the presentation.

The implications for yields therefore might mean that if a lot more people end up trading the underlying onshore bond market, which would be more liquid with better price action, the offshore market will become more volatile, leading to an increased risk premium for investing in the offshore market.

So you get two forces, money flowing into China’s more liquid domestic market with more attractive yields, and an increasingly marginalised Dim Sum market.

"Eventually you can see the yields offshore will become higher than the yields on shore, because of the increased volatility," the investor explains.

What’s the trade to take advantage of that?

One idea is to look at the forward CNH curve, say traders. By paying in the CNH swap using a forward-forward, from say 6 months out to three-years, investors will profit in the future from the convergence and eventual switching in interest rate differentials between onshore and offshore.

That is a trade that can take advantage of the idiosyncratic nature of the CNH FX forwards curve. Historically the main paying interest was European corporate hedging, but most hedgers quickly realised that out to six months it had gotten very expensive, and so those hedges got rolled out into the 1-year, 2-year and 3-year parts of the curve.

Now that activity has accelerated, with many of the asset liability desks of Asian banks also starting to do the same. In particular, say traders, Chinese banks have been very active in selling and buying dollars and buying and selling yuan, initially at the six-month point of the curve, but now they have started in the 1-year and will eventually go into the 2-year, say traders. At the same time, the Dim Sum issuance, which tends to be in the 2 or 3-year period, has created the receiving interest.

Last week’s presentation provides some good support for the trade, because the message from China’s bond delegation was very clear.

The renminbi is here, and if you’re serious foreign investor, the on shore bond market is open, don’t mess around with this peripheral market, and we are going to compete with the major bond markets.