The nascent market for "dim sum" bonds - denominated in Chinese yuan but issued outside the mainland - is poised for strong growth this year, gaining traction even as China opens its own markets to lure investors' money directly inside its borders.
A suggestion by China's top securities regulator last week that the world's second-largest economy could sharply expand investment quotas for foreigners fueled worries that the offshore yuan bond market may get overlooked if investors stampede straight into China.
With mainland bonds traditionally offering beefier yields than their dim sum equivalents, that possibility weighs heavily on the market.
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But fund managers and analysts say the diverse products and regulatory transparency of offshore markets will continue drawing issuers and investors to dim sum bonds - especially given the risks that persist in mainland markets.
"The advantages of the dim sum bond market lie in its flexibility, transparency and different types of credits investors can choose from," said Becky Liu, an analyst with Standard Chartered Bank.
The biggest deterrent to foreign investment on the mainland, she added, was restrictions on offshore remittances and requirements for government approvals.
Dim sum issuance started strong this year, with nearly 10 billion yuan ($1.6 billion) of orders chasing three dim sum bonds in the first two weeks of January, eventually raising a combined 2.9 billion yuan.
Issuance volume for the year is expected to rise about 20 to 30 percent from 2012, to 320 billion to 350 billion yuan including certificates of deposits (CDs), Standard Chartered said in a report on Monday.
The overall dim sum bond market, at 244 billion yuan in outstanding volume without CDs or 375 billion yuan with CDs, according to HSBC estimates, is tiny compared with the 24 trillion yuan onshore bond market, excluding CDs.
But it far exceeds the amount of overseas investment in mainland bond markets under the main RQFII and QFII quota schemes set up for qualified foreign institutional investors. And while total foreign investment in China's bond market - including foreign institutions buying on the interbank market - would be difficult to estimate, overseas participation remains severely limited by capital controls as China fears unrestricted fund flows could disrupt its economy.
That will inevitably change, given China's ambitions to be a major player in global financial markets with a global reserve currency, and it is steadily developing and expanding channels to let foreigners invest directly in its capital markets.
Against that backdrop, China's top securities regulator Guo Shuqing stirred up worries over dim sum bonds' future last week when he said the Renminbi Qualified Foreign Institutional Investor scheme, launched a little over a year ago to boost foreign portfolio investment in the mainland, could be expanded ten-fold.
The program, which started at just 20 billion yuan with a focus on investment in the mainland bond market, was boosted to 70 billion yuan last year to allow investments in the stock market through exchange-traded funds.
While some analysts doubt that China would actually expand the RQFII program at the dramatic 10-fold pace that Guo suggested, market players say that even such a drastic increase - which would catapult the RQFII scheme past the size of the dim sum market and even the overall volume of offshore yuan deposits - would be unlikely to take the steam from dim sum bonds.
At the time of RQFII's initial launch, analysts note, foreigners gave only a lukewarm reception to onshore yuan bond funds, in part due to the narrow scope of bond products available on the mainland.
"Investors are rational and they are still buying in the CNH (offshore yuan) market," said Sean Chang, head of Asian debt investment at Barings, adding that investors would choose which market to enter depending on the risk profile they are seeking.
And while yield spreads remain a key potential disadvantage for dim sum bonds, with the benchmark 10-year government bond onshore enjoying a premium of around 50 basis points over the offshore equivalent, the gap has narrowed substantially over the past few years.
Analysts believe the spread will tighten further as cross-border channels for yuan flows expand, and the pace is likely to accelerate as China loosens the reins on its capital account.
For some bonds, especially in the high yield sector, the dynamics are changing and some offshore yields now exceed their onshore counterparts, as Europe's debt crisis and slowing global growth dampened investor appetite for risk in the offshore market last year.
Shandong Chen Ming Paper Holdings Ltd's 2014 dim sum bond, for example, is now trading at 8.741/11.613 percent, while its 2017 onshore bond is only trading at 5.13/5.23 percent.
Foreign investor interest in the onshore market may focus mainly on bonds issued by the Chinese government and policy banks if the quota is expanded, said Yang Xi, a fixed-income analyst at Citic Securities.
Familiarity is another issue with foreign investors, who often know little about Chinese issuers and areF wary that most in the onshore market lack a credit rating from an international rating agency. In the offshore market, however, issuers with international ratings accounted for about 72 percent of total issuance volume last year, up from 49 percent in 2011, according to Bank of China International.
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The offshore and onshore markets are also both getting a lift from a quickening in the yuan's appreciation, which analysts forecast at around 2 percent to 3 percent for the whole of this year compared with 1 percent in 2012. Long positions in the yuan have reached a two-month high, a recent Reuters poll showed.
The premiums of dim sum bond yields over the average yield for Asian local currency bond and over Asian U.S. dollar bond yields are also attractive, not just for the Hong Kong investors but also for global investors, Barings' Chang said.
The HSBC dim sum bond average yield stood at 3.58 percent on Wednesday, while the bank's Asian dollar bond average yield was 3.47 percent.
Chang expected the total return of dim sum bonds this year to reach 5 to 6 percent, including the foreign currency gain, well above his forecast for the Asian dollar bond market.