Foreigners try new strategy in China’s bond China’s

By BLOOMBERG

BEIJING • China’s deleveraging campaign has foreign investors flocking to the nation’s short-term bank debt.

A sell-off in the country’s onshore bonds last month — triggered by signs that policymakers are determined to rein in speculative borrowing — encouraged offshore investors to home in on a particular slice of the market that might insulate them from turmoil.

They’re called negotiable certificates of deposit (NCDs), securities based on a deposit by one bank into another. Mainly issued by small and medium lenders, they’re short-dated, so bear less credit risk.

Overseas holdings of NCDs jumped nearly sixfold in the two months through September, vastly outpacing the 18% gain for the overall onshore bond market, according to official data.

And the debt may only get more appealing through year-end, with rates likely to rise thanks to seasonal dynamics.

“NCDs are in a sweet spot,” said Shan Kun, head of local-markets strategy in Shanghai at BNP Paribas SA, which has ranked the notes as one of its top recommendations this year.

“Because liquidity will likely tighten in the coming two months, as cash demand typically rises toward year-end, the contracts will be very attractive due to the higher yields.”

NCDs have surged as smaller lenders found it hard to raise funds through other methods thanks to a regulatory crackdown on parts of the shadow-banking industry.

Yesterday, a front-page commentary in the central bank-backed Financial News said that authorities should step up efforts to clean up all kinds of “financial mess”.

With more than eight trillion yuan (RM5.12 trillion) outstanding, NCDs make up the fourth-largest type of bond in China, after sovereign, local government and policy-bank debt.

Investors can get 4.57% yield on top-rated three-month notes — better than the 3.89% on 10-year government bonds.

With prospects for yet higher yields thanks to the Chinese leadership’s focus on reducing financial risks, investors can reinvest maturing securities at higher rates. One-year NCDs offer 4.62%.

Rather than credit risk — which is limited by their short tenors — the biggest danger with NCDs could be moves by regulators to cap their issuance, leaving investors without fresh securities to roll their cash into.

Officials last year stepped up scrutiny of the instruments, which are used as a funding source for leveraged bond investments by some institutions.

In October this year, issuance of NCDs slowed to a five-month low of 1.3 trillion yuan. Scarcity value could also see prices rising, pulling down yields.

For now, NCDs appear to be the flavour of choice for foreign investors, who were given a new channel to enter China’s onshore market with the Bond Connect that started in July. Corporate bonds suffer from a relative lack of transparency, and trading volumes can be low.

Government notes, unless held to maturity, would be disadvantaged by any continuation in last month’s sell-off.

The popularit y of NCDs is related to “the structural and fundamental, long-run trend that more and more foreign investors will be interested in domestic fixed income”, said MK Tang, senior China economist at Goldman Sachs Group Inc in Hong Kong.

“So long as the NCDs’ yields remain high and hedging costs remain low, the proposition for this trade will likely remain, and inflows into the notes will remain pretty solid,” he added.

Overseas investors typically use cross-currency swaps to hedge the foreign-exchange risks of buying onshore securities.

And with three-month offshore yuan cross-currency swaps at 85 basis points lower than the yield on NCDs of the same tenor, there’s a positive return.

“In the current environment, NCDs do offer an interesting, attractive proposition for short-dated investments in China’s onshore market,” said Angus Hui, a Hong Kong-based Asian fixed-income fund manager at Schroder Investment Management Ltd, which has been investing in the securities.

“For foreign investors, in the near term, the interest in adding NCDs holdings will likely increase.”