CNH Bonds: An Introduction

It was the story back in 2011; and one of the fastest growing local-currency corporate-bond markets: The offshore Chinese Yuan bond market. Today we bring you a brief introduction to CNH.

Disclaimer: do note the the following information is for educational purposes only, and does not constitute advice for investment.

The story

  • It is one of the fastest growing markets in Asia: annual issuance of CNH bonds has grown 16x faster than China’s economy
  • On a 3-year basis, this asset class has also done exceptionally well. Fueled by expectations of currency appreciation, total returns on CNH bonds exceeded 5% on an annualised basis
  • Not to mention, it is one of the most convenient ways to invest in China bonds, as access to onshore markets are restricted, though these has somewhat eased given recent market-liberalisation measures

 

What drives buying?
Whilst buying into CNH bonds have picked up lately, they are no longer perceived as the same ‘dim sum darlings’ back in 2011. Liquidity in the offshore Yuan market is key in driving purchases of such bonds, and there are three sources of such liquidity:

  1. Cross-border trade-finance: which in turn promotes the need for financing from both financial institutions and corporations, as Yuan increasingly becomes the currency of choice for trade settlements
  2. Retail deposits: are arguably a less significant source of liquidity, given the conversion limit of RMB 20,000 per day
  3. Central bank swap lines: the PBoC has been actively setting up swap lines with foreign central banks, and that allows expansion of the CNH liquidity pool

 

What can one buy?
Certificate of deposits (CDs)
Post the onshore liquidity squeeze last year (remember when 7-day repo hit 10.77% in June 2013) and driven by interest-rate liberalisation reforms, banks were encouraged to seek longer-term funding. Certificate of deposits have since emerged as a significant portion of the CNH market. They seem to be less liquid in the secondary market, and can be issued under reverse-inquiry. CDs typically have term to maturities of 12-months or less. Although CDs can be issued by foreign banks, most of them are done by Chinese financial institutions

CNH Bonds
Before we even attempt to answer the question of what to buy, the more fundamental question is this: how do you even value what you buy? For USD corporate bonds, we look at credit premium/spreads against government bonds. For SGD corporate bonds, one could benchmark that against the swap-offer rate. So what makes CNH bonds that difficult to price?

The conundrum is the lack of a liquid/efficient risk-free curve. The Ministry of Finance issues CNH Government Bonds, but only twice a year. These bonds trade at bid-offer spreads wider than those of corporate bonds, and some bonds will never see daylight post issuance, which in turn makes pricing difficult. The CNH HIBOR IRS market, at its infancy, proves to be difficult as a benchmark as well. The preferred method I would use to evaluate CNH bonds, are asset swap spreads against the CNH CCS curve.

The CNH CCS market is one of the most active cross-currency swap markets in Asia, and is liquid up to the 5-year tenure in decent sizes.

 

So what are you buying exactly?
Credit rating wise, most of the CNH bonds would be unrated. The almost-irrational and relentless pursuit of a Yuan-appreciation dream back in 2011 afforded issuers the lee-way of issuing cheaply without the need for a credit-rating even. A quick-glance on outstanding bonds estimates that more than 50% of the bonds would be unrated

Duration wise, most of the bonds sit comfortably in the 1-3 year space, dominated by certificate of deposits (CDs). In my opinion, the short-duration nature of the market is unsurprising, as it is challenging, given how fluid FX and interest-rate policies are in China at the moment, to take a 5-10-year view on CNH and Yuan interest-rates. As the capital accounts liberalise further, there should be more pressure on CNH yields to converge towards that of CNY too.

Yields would be the main point. Most would sit in the 3-4% range, which are not overly exciting (unless you’re willing to go down the credit curve, i.e. very high yield). Given the short-duration nature of the market, very often you are expressing a currency view as much as an interest-rate view when you gain exposure to CNH. In fact, the expectation of currency-appreciation remains the key driver of low yields in the market, as dictated by interest-rate parity. I am not an expert on detailed valuations, but I can roughly, provide a cheat sheet on what to expect, when you embark on a CNH bond purchase. All valuations given in spreads above 3-month USD LIBOR of equivalent maturity:

Government bonds: 60-80
Policy-bank bonds: 120-140
Foreign financial-institutions: 70-90 for household foreign banks
Financial institutions (big 4): 140-160
Multinational Corporates (rated A/A-): 80-120; with about 20-30 bps difference attributable to ratings. Country/sector risk also matters

Why would you buy?
Currency really. With yields priced lower than most of its EM Asia counterparts (Malaysia, Thailand, Korea etc), the carry profile of CNH bonds is almost comparable to Singapore Government Securities (SGS); and we are talking an EM market here. In short, I personally think it’s market worth watching, given that we have now witnessed aggressive depreciation of the Chinese Yuan. It would have been a completely different story otherwise.