New world of retail debt

PUBLISHED : Monday, 25 July, 2011, 12:00am
UPDATED : Monday, 25 July, 2011, 12:00am


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A whole new class of Hong Kong retail debt investors is about to come into being as the government allocates its first retail bond. The creation of this inflation-linked bond, or iBond, has generated considerable interest despite the fact that bonds have consistently underperformed other assets. While it remains easy to be underwhelmed by the performance of bonds, they have their adherents.

This is especially the case today as investors are less inclined to look for high performance because they are seeking safe havens. Moreover, a bond issued by the Hong Kong government looks attractive compared with those issued by nations with crippling levels of sovereign debt.

If inflation is higher than 1 per cent, Hong Kong's bond will pay a rate linked to the composite consumer price index, a measure of inflation, over a six-month period.

This hardly looks exciting but it may be just the ticket for investors seeking wealth preservation, as opposed to high returns that tend to come with high risks.

In a marked departure from normal practice, the Monetary Authority produced a clear prospectus for the bonds, succinctly listing benefits and risks. It points out that the market value of the bonds (relevant to holders who wish to trade their bonds, rather than keep them until maturity in July 2014) can decrease if Hong Kong dollar interest rates increase.

This is accompanied by an exchange rate risk because of the local currency's fixed link to the US dollar; so bond investors might find they can get higher returns from overseas bonds with appreciating currencies. The other big risk is liquidity. Although at a decent size of HK$10 billion, the bond's heavy retail allocation means there will be fewer institutions holding the instrument and trading it, which means it could be illiquid. Investors who want to trade iBonds may have to settle for selling at an unsatisfactory price.

On the positive side, retail investors can buy these bonds directly. Generally, they have to make bond investments via a bond fund because most bonds are not issued to the retail market. This means dealing with the usual proliferation of fund managers' charges and taking on the risk of their competence in maintaining the portfolio.

The bond issuer, the Hong Kong government, enjoys an AAA/Aa1/AA+ rating (S&P/Moody's/Fitch). Moreover, the coupon on these bonds is far higher than interest rates offered by banks even for long-term deposits in the local currency, which at present stand at small fractions of 1 per cent.

Furthermore, local investors would be getting into bonds at a time of renewed global interest in the instrument. Last year, US-based mutual fund companies attracted investments of nearly US$400 billion in bond funds, compared with a net outflow of US$9 billion in 2009. This was mainly explained by a flight to safety that played out during the credit crisis. However, some of this money has flowed into fancy leveraged and hedged bond plays that turn staid bonds into something rather different.

Hong Kong, with its pristine sovereign credit rating, seems like an ideal issuer from which to buy a bond. However, there are some interesting figures from Economic Data, a research firm, covering corporate bond performance from 1988 to 2010 showing that the best average long-term returns came from bonds with a modest BB rating.

The same picture does not necessarily hold true for sovereign bonds of the type being issued in Hong Kong (certain sub-investment grade European credits are looking a little rocky), but it is a reminder that a higher credit rating means reduced risks and returns.

It may be argued that as the equity markets continue to slump, the best investment bargains are to be had in shares, but that does not preclude carving out a place in a balanced investment portfolio for these Hong Kong bonds. Those who missed out on the issue always have a chance to buy in the secondary market - they may be able to do so at below the issue price.