The Development of Hong Kong Debt Markets

Over the past 10 years, the Hong Kong government has contributed significantly to the growth of capital markets by introducing a number of measures designed to further develop an efficient infrastructure for the Hong Kong dollar bond market. These measures include the establishment in 1990 of the Central Moneymarkets Unit, which provides an efficient settlement, central clearing and custodian system for Hong Kong dollar debt securities, and the introduction of the Exchange Fund Bills and Notes Programme to create a benchmark yield curve extending to 10 years.

Central Moneymarkets Unit

The Central Moneymarkets Unit (CMU) was set up primarily to provide computerized clearing and settlement facilities for Exchange Fund Bills and Notes. In December 1993, the Hong Kong Monetary Authority (HKMA) extended the service to other Hong Kong dollar debt securities. Since December 1994, the CMU has been linked to international clearing systems such as Euroclear and Cedel. This has helped to promote Hong Kong dollar debt securities to overseas issuers and investors who can make use of these links to participate in the Hong Kong dollar debt market. In December 1996, an interface between the CMU and the Real-Time Gross Settlement (RTGS) interbank payment system was established. This enables the CMU system to provide its members with real-time and end-of-day delivery versus payment (DvP) services. Other market infrastructure enhancements by the CMU include the launching of a Securities Lending Programme for private sector securities in December 1997. The aim of this programme was to enhance the liquidity of private sector debt securities by providing a mechanism to make securities held by long-term investors available for short-term use by more active market participants.

The Hong Kong Monetary Authority launched the Exchange Fund Bills Programme in March 1990. Exchange Fund Bills and Notes are Hong Kong dollar debt securities issued by the HKMA. The Exchange Fund Bills and Notes constitute direct, unsecured, unconditional and general obligations of the Government of the Hong Kong SAR for the account of the Exchange Fund.

The Exchange Fund Bills and Notes Programme ensures the supply of high quality Hong Kong dollar debt paper that can be employed as trading, investment and hedging instruments. Banks that maintain Hong Kong dollar clearing accounts with the HKMA can use their holdings of Exchange Fund paper to borrow Hong Kong dollars overnight from the discount window. Under the programme, bills that have tenors of less than one year are regularly auctioned by way of public tender. To facilitate the management of liquidity by banks participating in the RTGS, three tap issues of 28-day Exchange Fund Bills have been issued since November 1996. As banks in Hong Kong have become more proficient in managing their intraday liquidity, demand for tap issues has fallen. Consequently, the HKMA has gradually reduced the size of each of the tap issues of 28-day Exchange Fund Bills and replaced them with a range of longer term Exchange Fund Notes.

Two-year and three-year Exchange Fund Notes were introduced in May 1993 and October 1993 respectively. This was followed by the inaugural issue of five-year Exchange Fund Notes in September 1994, seven-year Exchange Fund Notes in November 1995 and 10-year Exchange Fund Notes in October 1996.

As at September 30 2002, the value of outstanding Exchange Fund Bills and Notes totalled HK$116 billion.

Corporate Bond Market

The private sector bond market is currently just over twice the size of the Exchange Fund Bills and Notes market. As at September 30 2002, the total value of outstanding private sector bonds was HK$408 billion. The largest issuer category was local banks and corporations, followed by international banks and then supranational bodies.

Market History

According to available records, the first debt market issue in Hong Kong was a certificate of deposit issue launched in September 1977 by Chase Manhattan Bank. The issue size was HK$100 million – a large issue at the time. It was a five-year issue with a coupon rate of prime but subject to an interest rate floor of 5.25%.

The first fixed rate issue was launched in July 1980. It was an 18-month issue and carried a coupon of 10%. The issuer was Banque Paribas and issue size was HK$70 million. The interbank money market was still rather undeveloped at that time and certificate of deposit issuance was the only way for international banks to raise Hong Kong dollar funds.

The first swap driven issue occurred in 1984 when interest rate swaps were introduced into the Hong Kong dollar market. The coupon of the issue was 11.625% and the swap counterparty was a major property company in Hong Kong.

Supranational issuers have also played an important role in the development of the Hong Kong dollar bond market. The first supranational issue was launched in 1989 by the World Bank which was the first supranational issuer to tap the Hong Kong dollar market after the Hong Kong government granted tax exemption on interest and capital gains on holding supranational paper. The availability of this type of high quality paper helped to attract investor attention and to enlarge the investor base for Hong Kong dollar bonds.

Current Market Conditions

The Hong Kong dollar bond market has developed rapidly in the last several years. New issue volume was below HK$100 billion in 1997 but has grown to a level of between HK$150 billion and HK$180 billion per year in the last two years. While the floating rate market has remained fairly stable, there has been substantial growth in the fixed rate market. This is a result of more conservative investment attitude after the Asian financial crisis and a deflationary environment that gives Hong Kong dollar bond investors an attractive real rate of return.

Excluding the Yen bond market, the Hong Kong dollar market is the second largest Asian currency bond market, ranking just after the Korean won market. It is the most open market among the Asian currency bond markets although in terms of diversity of issuers, the Korean won and the Singapore dollar markets seem to show a greater range.

At a global level, the Hong Kong dollar is an important medium-term note (MTN) issuance currency. In 2001, the volume of MTNs denominated in Hong Kong dollars ranked just after the US dollar, euro, yen and British pound as the fifth most popular issuance currency. However, the average size of Hong Kong dollar issues is small relative to these other four currencies.

In terms of issuer type, international banks have replaced supranational entities as the most active issuers. Supranational issuers normally have more aggressive issuing targets than international banks. With investor interest increasingly concentrated in the short end of the credit curve, issuance by international banks has more than doubled in the last two years.

The Hong Kong dollar market is primarily a private placement market. Issue size typically is around HK$100 million to HK$200 million. Usually, there is only one arranger taking down the issue from an issuance programme and selling the paper to a small number of investors. The private placement nature of the market means the secondary market has not been very active because:

· a small issue size means there are a small number of investors involved which generally leads to lower liquidity; and

· in a private placement, banks other than the lead managers will not feel obligated to make a market on an issue in which they have no involvement.

In terms of tenor, the market is dominated by three to five year issues, which represent about 65% of total issuance. Tenor longer than seven years only represents 3% of the market. This explains why many Hong Kong issuers have to issue in the US dollar market if they want to obtain long tenor, although almost all of them will enter into a HIBOR/LIBOR basis swap to hedge the US dollar proceeds back to Hong Kong dollars.

Although many investors are prepared to go down the credit curve, the Hong Kong dollar market is still a high investment grade market with single A or better rated issues accounting for 80% of total issuance. It is expected that the Hong Kong dollar market will remain a high-grade market for the foreseeable future.

Institutional Investors

Investors in Hong Kong can broadly be divided into three major categories: the retirement funds, which are commonly referred to in Hong Kong as Mandatory Provident Funds (MPF); the Hong Kong banking institutions; and Hong Kong government-related institutions.

The MPF scheme was introduced in December 2000 and covers over 90% of the Hong Kong work force. Under the MPF scheme, both employer and the employee are obligated to contribute amounts equivalent to 5% of the employee’s monthly income (mandatory payments are only due on the first HK$20,000 of monthly salaries, i.e. the maximum mandatory payment for employer and employee is HK$1,000 each per month) to the MPF. The size of the retirement fund market in Hong Kong in mid 2002 was more than HK$200 billion. It is expected that when the scheme is fully mature, the total size of this market will grow by HK$36 billion per year.

Banking institutions are the largest investor category in Hong Kong. The total amount of Hong Kong dollar deposits in the banking system is currently about HK$1.8 trillion. As at Oct 2001, banking institutions in Hong Kong were holding Hong Kong dollar non-government bonds worth about HK$230 billion in their portfolios. Under the banking regulations in Hong Kong, banks have to keep 25% of the deposits accepted by them in liquid assets. Among other things, debt securities are regarded as liquid assets.

Government-related institutional investors include the Housing Authority, the School Fund, the Hospital Authority, etc. Although not strictly a government-related institution, The Hong Kong Jockey Club is also an important Hong Kong dollar investor. The investment subsidiaries of a couple of central banks in the region are also significant buyers of high-grade Hong Kong dollar bonds.

Retail Investors

Unlike as is the case in many other markets, in Hong Kong there is currently no overlap between the institutional and the retail markets. Institutional investors do not participate in the retail market due to its tight pricing. Retail investors cannot buy institution-targeted issues due to the large denomination. This contrasts with other public markets where both institutional and retail investors get the same price. In the equity IPO market in Hong Kong, retail investors usually get a better deal than institutional buyers.

Hong Kong Mortgage Corporation continues to be a pioneer in the development of the retail bond market. The corporation has tried a variety of ways to access the retail market some of which have been more successful than others. One of the first strategies was to use stockbrokers to distribute using the equity IPO mechanism. However, this proved to be a costly and ineffective distribution channel. A small group of banks with retail branch networks were then signed up to distribute bonds over the counter. This method was proved to be much more effective as bonds are good substitutes for bank deposits. The number of banks involved in recent retail targeted issues has expanded to more than 10 and the number of branches involved to nearly 500. The introduction of underwriting banks has helped issuers shift a significant amount of market risk to the underwriters.

There are a number of factors contributing to the quick development of the retail market. The current low interest rate environment and a conservative investment attitude are two key influences. Public awareness work and educational campaigns undertaken by the Hong Kong Capital Markets Association is another key element. The increasing awareness of wealth management by banks and their customers and the introduction of investment accounts are helping to make bond purchases over the counter as convenient as buying stocks through brokers. With the removal of the interest rate cartel, banks must now increasingly compete more on non-deposit products and are therefore more eager than before to help selling bonds. In the past, banks were reluctant to sell bonds as they were regarded as directly competing with deposits.

The Securities and Futures Commission has recently adopted a more “issuer friendly” attitude towards new bond issues. This has made the issuing process much smoother and issuers are now less exposed to market risks. And under the leadership of the Financial Service Bureau, outdated laws governing the issuance of bonds as established in the Companies Ordinance and the Protection of Investors Ordinance are being reviewed.

Industry professionals have welcomed these changes and hope to see additional steps taken by the regulatory authorities to further improve the environment for new bond issues. In particular, we look forward to seeing the prospectus requirements for bond issuance to be made less onerous than those for equity requirements as these two instruments entail very different risks.

Written by Mr. Tony Li

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^{The Hong Kong Capital Markets Association}