Capital markets: FTZ bonds struggle for survival

By Noah Sin

The Shanghai Municipal Government sold the first freetrade zone (FTZ) bond in December 2016, cracking open a market that allowed foreign investors to use offshore renminbi to buy bonds in the onshore market. 

Those deals then paid back in offshore renminbi at redemption. The pioneering transaction was good news for foreign underwriters. The China subsidiaries of DBS, HSBC and Standard Chartered helped sell the Rmb3 billion ($435.4 million) deal, which was priced with a coupon of 2.85%. The bond was trading at 3.0702% as of August 30, according to China Central Depository and Clearing’s data. 

That appeared to be a good start but nothing else has followed. Shanghai’s bond remains the only FTZ deal in the market and only two other issuers have since been approved to issue such bonds – Shanghai International Port Group (SIPG) and AVIC International Leasing, according to the National Association of Financial Market Institutional Investors (Nafmii). AVIC only gained approval on May 15, but SIPG has been considering the possibility of issuing since May 2016. FTZ bonds have not proved enticing so far. A big reason that helps to explain the dire state of FTZ bonds is the arrival of Bond Connect.

Launched in July, Bond Connect opened up the whole of the interbank bond market (CIBM) for foreign investors to trade from Hong Kong. This powerful feature makes the concept of an onshore-to-offshore market, which less than a year ago seemed so innovative, appear outdated and irrelevant.

“When the idea of FTZ bonds came out, the onshore market was nowhere near as open as it is today,” says a source familiar with Nafmii’s thinking. “This partly explains why issuance volume has been so small.”

But Bond Connect is not all bad for FTZ bonds. By making onshore renminbi bonds available, investors now have the opportunity to arbitrage between onshore, offshore and FTZ-issued RMB bonds, says one Shanghai FTZbased syndicate banker with a domestic firm. “As long as there are two RMB bond markets, there are always differences in pricing between the two types of bonds,” the source says.

“Now that international investors can buy onshore bonds through Bond Connect, they can pick and choose between onshore and offshore bonds depending on what the yields are like.” Buying FTZ bonds is also easier for foreign investors than accessing onshore bonds through Bond Connect, which has a more complicated ownership structure, according to Tiecheng Yang, a partner at Clifford Chance.. 

“One major concern of foreign investors [on Bond Connect], similar to that under Stock Connect, is the nominee arrangement and beneficial ownership,” he says. Under Bond Connect, the Hong Kong Monetary Authority’s Central Moneymarkets Unit (CMU) acts as the nominee holder of bonds on behalf of investors.

“FTZ bonds do not have such an issue because the overseas investors are required to directly open cash accounts under their own names with China Central Depository and Clearing and the Shanghai Clearing House,” Yang says. 

“The ownership is thus clearer and simpler.” Yang adds that nominee or beneficial ownership is not a legal concept clearly defined under PRC law, and although the People’s Bank of China has made it clear that investors can exercise their rights through the CMU as the nominee holder of their bonds, it remains uncharted waters for foreign investors.

“In the absence of relevant precedents and clear rules, uncertainty still lingers among foreign investors, especially those whose investments may be subject to foreign laws that require more concrete and explicit legal recognition of beneficial ownership,” he says. 

Unlike Bond Connect, FTZ bonds have enjoyed much less policy support. Regulators have said and done little as volumes remained stagnant, and allowed key issues such as tax to be undefined more than a year after they proposed the idea.

“No tax benefit for the FTZ bond pilot scheme has been announced,” says Yang. “It still needs to be seen whether there will be any preferential tax treatment and how they will be implemented.” Market participants hoping for clarity on policy are likely to be disappointed, given that regulators have not even bothered with the most basic question of what an FTZ bond is, says the source close to Nafmii.

“There are no distinct rules to define these bonds,” the source adds. Despite all of FTZ bonds’ shortcomings, the source said FTZs were always intended as pilot areas, a place where innovation begins rather than ends. They may also be helpful for investors who want to gain RMB exposure but are looking for a broader set of choices than the two domestic bond markets, says the source, adding: 

“As long as these bonds exist, it can always offer another option for investors, just as the interbank market offers over the counter trading as an alternative to exchange trading.”