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this issue

Asian Bond P.2 - 3 HKD Bond P.3 - 5

2017 market outlook P.5 -6 E-newsletter 2016—Special Issue, 07 Nov 2016

Hong Kong, Asian bonds adapt to changing global dynamics Amid negative rates in Europe, a likely interest rate hike in the US, and market liberalisation on the mainland, fixed income in Hong Kong is making quiet progress

Supported By:

HSBC Global Asset Management

Exclusive Roundtable

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Participants:

Vincent Chow, CFA

Group Treasurer

The Hongkong Electric Co., Ltd

Raymond Liu

Senior Vice President (Finance)

Hong Kong Mortgage Corporation Limited

Alfred Mui

Director, Head of Asian Credit

HSBC Global Asset Management

Darren McShane

Mandatory Provident Fund Schemes Authority

Chief Regulation & Policy Officer and Executive Director

Jelmer Veltman

Investment Consultant

Willis Towers Watson

Desmond Yu

Chief Investment Officer

Peak Re

Moderated By:

Alan Taylor

(on behalf of Asia First Financial Intelligence)

AF: In the past few years, Asian bonds have developed as

a separate asset class. What do you think has been

driving this?

Alfred Mui: We have seen quite a bit of improvement in terms of the market depth, liquidity and diversity of the Asian credit investment universe. Of course, the market is not equivalent to the scale of the US market, but is increasingly behaved like a stand-alone asset class, with its own supply and demand dynamics amid rising onshore and regional demands. Separately, on the macro front, a number of countries, for example, Indonesia, India and Korea, all have seen improvement in terms of their fundamentals, which has created an asset class that is less vulnerable to external shocks, as evidenced by the recent DB debacles and Brexit news.

Jelmer Veltman: I think there are two points. Firstly, investors in Asian bonds have been relatively worry free compared to other markets. Russia, Brazil or South African markets, for example, have spooked some investors, but the last few years have been relatively stable for a bond investor in Asia. Secondly, the expansion of coverage by asset managers, who have developed capabilities in Asian bonds, means that Asia is a more comfortable place for investors to

from left to right: Alfred Mui, Jelmer Veltman, Darren Mcshane, Alan Taylor, Desmond Yu, Raymond Liu, Vincent Chow

“investors in Asian bonds have been relatively worry free compared to other markets”

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allocate their money to, as they know that asset managers have built up their skills in this area.

Vincent Chow: I have a little bit of a unique perspective on this in that I’m also an issuer. In Asia, what we see is that there are some European investors who need to diversify their bond portfolios and that adding some names from Asia helps them to do this. Of course, there is also still a little bit of a yield advantage in buying Asian names.

Desmond Yu: From the perspective of an insurance company, there is a strong demand for Asian bonds, both US denominated and even on the local currency side. However, it is not only from insurance or reinsurance companies that we see this demand but also pension funds, and other investors who have long duration liabilities. These investors need to invest in fixed income assets to hedge their interest rate risks. That’s one reason why you see insurance companies and pension funds as being key to local bond issuance in Asia, or indeed, elsewhere in the world.

AF: Are the long tenors that the insurance companies and pension funds require, easily available?

Desmond Yu: They can be difficult to buy. I hear that a lot of Chinese insurance companies who issue policies that are over 20 years have been struggling to find long duration assets, such as local bonds, to back these liabilities. For life insurance companies, when they distribute a product, it is very difficult for them to gauge what will happen in the investment market in the next 12-24 months (the markets now change a lot more quickly than people think), so there has been ongoing demand for very long duration assets in the market to match these types of liability.

AF: Jelmer, one of your colleagues was quoted as saying global investors are dumping European and US bonds for Asian bonds. Do you think he’s right, and if so, what’s driving that?

Jelmer Veltman : I think he’s right. This is a trend that we are seeing, but I don’t think it is to do with Asian fixed

income itself, it’s more to do with the rest of the global bond market. Investors, generally, have been allocating to global bonds on an automatic-pilot basis. If they invest in global debt, they are automatically investing in European debt. But if you think about it, the function of a bond allocation is that it is part of a defensive portfolio and if you ask investors, they will say it is for capital preservation and downside protection. However, if you think about the current state of the European bond market, at the moment, capital preservation with bonds carrying negative yields is very difficult, as for downside protection, you need to have some yield buffer. If equity markets fall, bonds that have a zero or negative yield aren’t going to provide that protection. So when investors ask “Why do we actually hold European debt?” it becomes more and more difficult to justify it and in that context Asian fixed income assets make more sense and can provide a reasonable alternative.

AF: Has anything exciting been happening in the Hong Kong bond market recently?

Alfred Mui: Investor demand has gone up decently as evidenced from the pickup in private placement issuance and secondary activities, partly due to rising demand for insurance products following the trend for mainland tourists coming here to subscribe to insurance policies. Then at the retail level we’ve seen a structural shift of flows into Hong Kong dollar bonds. This is partly due to the less positive outlook for the renminbi, and also in part due to ultra-low rental yield on the physical properties, in particular the luxury end and insignificant HKD deposit rate. Therefore, if investors want to switch out from offshore renminbi deposits they need to find a place, and the Hong Kong dollar bond is one of the alternatives for that as evidenced by the ibond subscription. Even if you check with the sell side, every day or so now we see secondary enquiries at the retail level which we hadn’t seen before on that scale.

Vincent Chow: The market has deepened, tenor-wise and in the number of issuers. I remember when we used to issue private placements of about HK$100 million but these days I’m probably issuing HK$ 300-500 million. Recently, for the first time, I issued a 30-year bond. Maybe five years ago I wouldn’t have been able to place that sort of tenor. As an issuer we are very happy with that, because naturally we

Desmond Yu

Alfred Mui

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like to issue in Hong Kong dollars as our income is all in Hong Kong dollars. So from an asset and liability match perspective the development of Hong Kong’s bond market is helping us a lot.

Last year we tapped the Taiwanese market with a Formosa bond, but the problem was that while we could issue long tenors (of 20 or 30 years), we can’t hedge the currency exposure to that tenor, as the market only goes out to 15 years. This meant that I had a currency mismatch, as when the hedge matures I need to roll it over for another five or 15 years, which is a risk. With a Hong Kong dollar bond, there is zero foreign exchange exposure, of course.

AF: Are all the investors coming from Hong Kong or is there much demand from elsewhere?

Raymond Liu: Of course we see increasing investors and issuers coming in from the outside. If you draw the analogy between the Singapore dollar market and our market, both the corporate markets are a similar size but ours has lower secondary turnover (due to many buy-and-hold investors). However, if you look at the quality in Singapore, it is quite skewed towards the extreme end (in terms of credit), whereas Hong Kong is very balanced in terms of risk and ratings. When it comes to foreign issuers issuing in Hong Kong, as a market, we are competing with all the funding markets around the world. With negative rates in Europe and Japan, the USD/HKD Peg coupled with cost effective hedging swaps up to 15 years, Hong Kong can be competitive for both buy and sell sides.

AF: For investors does it tend to be buy and hold or are we seeing more secondary trading?

Alfred Mui: For now it is more buy and hold, given the pension funds and insurance companies buying for liability management. But at the same time, as I highlighted before, we have started seeing retail investors move out from RMB deposits to Hong Kong dollar assets, so they are also

picking-up some retail bonds in the market, so hopefully this will encourage sell sides to warehouse more inventories for purpose of facilitating more secondary flow trading.

Vincent Chow: I did see a bit of private bank demand in our last corporate bond issue. I would imagine that professionals acting for retail investors have learnt through the crisis that they need a decent allocation to fixed income. Of course, Chinese people, especially Hong Kong people, are often risk-takers, so they are used to investing in the stock market. But all the ups and downs of equities recently, have educated them about the need to have fixed income products in their portfolio and we see that helping the Hong Kong dollar bond market. A lot of private bank investors will be looking at US dollar-based assets, but I would imagine that through this demand, in time, we would also see more demand for HK dollar-issued bonds.

Jelmer Veltman: I think from the perspective of our clients, pension funds and institutional investors, the lack of liquidity in the Hong Kong dollar market, is still a big challenge, and is a real factor in their investment decisions. It is something that is holding them back from allocating to HK dollar bonds and they still much prefer the US dollar bond market. The lack of liquidity reduces flexibility for investors in changing allocations and when they need to make redemptions for cash flow reasons. A lot of these practical concerns make them reluctant to go to the Hong Kong dollar market, so they much prefer the US dollar bond market. Also, as the currency risk around the Hong Kong Dollar peg is not at the top of people’s minds, they are generally more willing to take pure US dollar risk.

AF: One would think that a Hong Kong dollar bond would be a good investment for someone approaching retirement age, but they don’t seem to be a popular choice. Why do you think that is?

Darren McShane: I suppose there is the speculative instinct, which Vincent talked about and which isn’t served very well by bonds. However, aside from that, while the allocation to bond funds in Hong Kong’s MPF is relatively small, just three per cent, when it comes to system-wide assets the allocation to global bonds is around 20 per cent, as investors get some bond exposure through mixed asset funds. To be honest, to my mind, that is where investors should be; they shouldn’t be making individual asset allocation decisions between classes.

As to why Hong Kong Dollar bonds aren’t attractive, it’s partly that bonds are neither attractive as a investment for people who want to take risk, nor are they the natural place for those who don’t want to do so, as these investors tend to go to capital preservation funds. There have been some sponsor initiatives to get people excited about bond funds,

Vincent Chow

“from an asset and liability match perspec-tive the development of Hong Kong’s bond

market is helping us a lot”

“we have started seeing retail investors move out from RMB deposits to Hong Kong dollar assets”

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but the uptake from the investor remains

muted. It’s not for us (as regulators) to be judgemental about this, but I wouldn’t say that’s a bad thing. In my own view, in a market like the MPF, where you’re forcing the whole working population into financial services, other people should be making

the hard decisions for them. That’s better than individuals deciding “I'm going to put a bit into a bond fund, a little bit into this equity fund, another bit into that one”, a professional should be really making those decisions for them. There’s a small niche of participants who might be capable of making those decisions and maybe that 3 per cent allocation number reflects that, though of course it could just be the outcome of a decision-making process like a throw of darts at a dartboard.

AF: We’ve seen on the retail side, that the government has been issuing inflation linked bonds, and the recent silver bond issue aimed at seniors shows that there’s clearly appetite there. Is there space for inflation-linked bonds aimed at the institutional market in Hong Kong?

Jelmer Veltman: I think the natural demand is definitely there for inflation linked bonds, say from pension funds looking to hedge their liabilities. The questions are what is the incentive for the government to issue them and whether it’s feasible.

Demsond Yu: From an insurance perspective, if you very long liabilities, perhaps an inflation linked bond might be an option, but if you are currently holding a rather short duration portfolio of bonds, this time might not necessarily be the best to look at inflation linked bonds, as there isn’t much expectation of inflation in the market. I think timing is a key factor when it comes to demand for inflation linked bonds.

Darren McShane: I think inflation linked products would be very attractive for a lot of people because they want to preserve their investment. However, if you look at who is going to issue them in an uncertain inflation climate, it probably comes back to the government and that puts you back where you started. The idea behind multi pillar retirement system is to diversify the funding of retirement savings away from the government balance sheet and government issued inflation-linked bonds would put it back on the government balance sheet.

AF: How is the opening up of the onshore renminbi market likely to affect the Hong Kong bond market?

Alfred Mui: I see it as a complement. When China gradually opens up the market, this encourages more two-way flows. That’s why recently we’ve benefited from onshore flows into Hong Kong from mainland Chinese investors wanting to diversify out from renminbi into other safer assets like Hong Kong dollars. Even if you look at the sell side, obviously the dim sum bond cnh business is shrinking in terms of revenue, the difference is made up by the expansion into the Hong Kong dollar market. Moreover HKD bond market is perceived as the proxy to the USD market owing to the peg with higher quality exposure bias and may not be seen as a direct competition with the RMB market unlike dim sum market.

Desmond Yu: Following the opening up of the onshore renminbi market, I think that it’s going to be more challenging from the issuer side to get strong demand from investors for offshore renminbi. From an offshore investors’ perspective, there was QFII and now there a much bigger fixed income market available for offshore investors in the interbank bond market, so there are Chinese assets with the same quality of issue as offshore, but a yield pick-up onshore. So the demand for the offshore RMB is not as good as it used to be two or three years ago.

AF: How do you see the outlook for the market in 2017?

Alfred Mui: I think that rates are heading nowhere. While there is another hike coming in the next few months, the increase will be gradual. I don’t think anyone expects to see something like the 1994 or 2004 rate hike cycle. So ‘carry’ is on everyone’s radar; and there is more ‘high hanging fruit’ out there than in the past. By this I mean that you need to be more selective in order to be able to enjoy carry, while avoiding all the traps and toxic instruments. I think plain vanilla bonds will still drive the market, as the option valuation is so low and investors are not paid to taking big risk from structure derivatives. Also, investors have learnt about not being too greedy, so that should benefit us as fixed income participants.

Jelmer Veltman

Darren McShane

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Jelmer Veltman: I think that the return expectations from bond markets will be low. That’s been a trend for the last few years, as yields are low. Equities have been on a great run since the financial crisis, so investors should adjust their return expectations downwards. I think in the context of Asian fixed income and also Hong Kong bonds, they should still have positive expectations. There’s no reason to expect severe headwinds ahead, but the expectations should be lower (interest rate) than they’ve been in the past given the current starting point.

Alfred Mui: We’ve seen a lot of demand from Japan and onshore China where investors want to diversify into the Asian dollar credit space. The supply of risk will not only come from China, we also see some maiden issuers coming from a wide array of sectors in India , for example pharmaceutical companies, renewable energy, industrials. I also anticipate that we will continue seeing more Asian issuers come into play to capture this market and to refinance. We expect that will help address the supply shortage in the market. We are still quite underrepresented in both the global/EM bond indices based on the shares of Asia to the global GDP.

Raymond Liu: The major consideration for the coming 12 months is the political environment. There will be a number of changes of leaders, not only in the US but also major European nations and if we see the momentum from Brexit and increasing populism continue elsewhere, change really comes across the board. The central banks may be pushed to change, or there may even be change in the central bankers themselves. For this reason I think overall political developments are something at which people will have to look closely in 2017.

Desmond Yu: Looking forward, there are going to be interest rate rises in 2017, but, I agree with Alfred, we will see a more gradual pace of rises. I think the Fed’ has been very hesitant to raise rates because of the uncertainty in the rest of the

world and I see that continuing. This means that it’s very challenging for an insurance operator like us to get good yield returns in the fixed income space. My other observation is that there are a lot more Chinese enterprises going offshore for their financing including into the US dollar space, and also into other currencies. These companies want to make overseas acquisitions, so the best thing to do to hedge their risk is to raise finance offshore. For this reason, I predict stronger demand from that angle.

Raymond Liu

“I think in the context of Asian fixed income and also Hong Kong bonds, they should still

have positive expectations.”