Finance

An Overview of Bonds in Hong Kong

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The Hong Kong Stock Exchange (HKEx) is China’s third largest stock exchange and the sixth-largest stock market globally.

The scope of its index-based products and services has grown to encompass a range of trading products, including shares, unit trusts, derivatives, and bonds.

Banks’ acceptance certificates (BACs) were the only bond product traded on HKEx’s markets for many years. However, since 2000 there has been an increased number of corporate bonds issued in Hong Kong by non-banks.

This increase was due to three main factors:

  1. falling interest rates encourage corporations to establish yield curves that are more closely related to their business cash flows.
  2. companies can issue debt securities with longer tenors than bank loans because securitization is not widely used in Hong Kong, and
  3. With the liberalization of bond markets, companies can issue debt securities more cost-effectively than bank loans.

The three factors mentioned above resulted in an increased issuance of non-bank bonds between 2000 and 2002 when interest rates fell rapidly, but this trend slowed down after 2003 when interest rates started to rise again.

Despite this slowdown in new issues, HKEx’s corporate bond market has grown significantly since historical records began.

Stakeholders

The composition of Hong Kong dollar bond issues is dominated by the retail sector (43% outstanding value), while government and quasi-government sectors account for nearly 25%.

Foreign currency bonds are issued primarily in US dollars, Japanese yen and Euros, with the latter making up 39% of outstanding value. Some issuers also issue instruments in pounds sterling and Canadian dollars.

Corporate bond investors include insurance companies, fund managers, banks, securities firms and major corporations seeking to diversify their portfolios or raise funds for general corporate purposes. Corporations can be categorized into three groups: financials (banks), service (insurance) providers and non-financial (real estate developers).

Banks’ corporate bonds tend to have a longer tenor than non-bank bonds, and the former is traded infrequently.

Type of Risks

Inflation risk –

The price of a bond can be eroded by inflation over time because it only pays out a fixed monetary amount. This makes companies who issue fixed interest rate bonds less attractive as their natural income declines with increases in inflation.

Risk of interest rates

Bondholders expect a return on their investment from the issuer, including an interest payment for borrowing money from them. If the issuer needs to borrow money from other sources to repay bondholders, this could increase the issuer’s costs. For example, the Royal Bank of Scotland’s 30-billion-pound sterling bailout will cost UK taxpayers 14 billion pounds due at 8% interest over10 years.

Liquidity risk

Bondholders are only likely to get back the money they initially invested in a liquid secondary market for their bond. This means that if the issuer needs to repurchase their bonds, then it will have to do so at current prices, not at the original issue price. The more liquid that the market is, the lower this risk.

Sovereign risk

There is always an element of sovereign default risk when investing in emerging markets because governments may change policies or legislation impacting investors’ rights and returns.

Currency mismatch

Suppose a bond is issued in one currency, but its cash flows are received in another currency. In that case, there could be potential problems with changing exchange rates due to the depreciation of one currency or another. This is known as currency mismatch or currency risk.

Credit Risk

Credit risk means that there is a chance the issuer will not meet its obligations to pay coupon payments on time, if ever. Potential investors can reduce this by analyzing debtors’ creditworthiness.

Convertibility risk

If an issuer has issued bonds denominated in one currency, they may find it difficult to repay these debts if their currency becomes less valuable.

Interest rate risk

When interest rates rise, their costs increase, but their revenue does not immediately go up. Hence, they must borrow more money at higher rates of interest, potentially leading to increased levels of debt which could be unsustainable over the long term. Corporations are also exposed to interest rate risk because the price of their bonds will fall as interest rates rise, potentially making them less attractive to investors and increasing costs.

Call/sinking fund risk

If the issuer has the right under the bond indenture to call (repay) or redeem (refund) bonds, then this can lead to potential problems for investors if their bond is called. This is because they may not be able to reinvest in another bond at a similar rate and so lose part of their income stream and diversity in an investment portfolio.

These are some of the risks. Click here for more information.

Abel Eino
the authorAbel Eino