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Hong Kong commercial banks may see an exodus of second-tier customers to cheaper funding sources on capital markets towards the end of the year, according to analysts.

The comments follow the latest cut to interest rates this week, which has taken the cost of funds to banks - or rates paid on their deposit accounts - close to zero.

This may put the brakes on further cuts to lending rates and make bond markets appear increasingly attractive to second-tier borrowers.

Savings deposit rates were cut to 0.25 basis points in the latest move and banks have said they were unwilling to see zero rates in Hong Kong.

That means any further cuts to lending rates priced off prime - reduced to 5.25 per cent on Wednesday - will have to come at the expense of the interest spread between the two. The outlook is for further cuts to United States rates.

Analysts say the best of blue-chip borrowers in Hong Kong typically pay a narrow spread above interbank rates on bank loans rather than have the loans priced off prime.

For such borrowers, bank loans remain cheaper in the present environment than capital markets.

The benchmark three-month Hong Kong Interbank Offered Rate (Hibor) dropped to 1.87 per cent yesterday and based on a spread of about 100 basis points above Hibor, a high-quality borrower would be paying less than 3 per cent for bank borrowings.

However, corporate customers paying prime - or anything above prime - will be examining the cheaper alternatives presented by refinancing bank loans, say analysts.

This is because they will be paying more than 5 per cent for bank borrowings and may expect to pay less - depending on credit ratings - by going to the bond market.

The appeal of cheaper funding costs aside, the bond market also will allow borrowers to stretch out the maturity of debt and do so by locking in to rates at the bottom of the cycle, analysts add.

'To the extent that the cost of funds from going to the capital markets is that much cheaper than going to the bank market, and to the extent that banks don't have much room to lower rates, it would seem that capital markets are the way to go,' said Calvin Wong, managing director of structured-finance ratings for Standard & Poor's.

Bond issues would particularly favour 'high yield' companies or those with a higher risk profile, said John Bailey, director and team leader of S&P's corporate group.

'We can see a flurry of new issues coming towards the end of the year because companies will be trying to lock in low rates and diversify their funding sources and extend their debt maturity profile,' Mr Bailey said.

HSBC head of credit research for Asia Pacific John Woods said bond markets were looking increasingly attractive as an alternative to bank lending.

'The problem is that the market is directed to high-grade names, which typically means that those who need it the least have the most, and those who need it the most have it the least,' Mr Woods said.

'You would have to find a segment of the investor base prepared to take it on - and in the US there have been emerging market funds which have done so.'

Issuers of such paper also would need a rating, Mr Woods said.

David Marshall, of ratings' agency Fitch, said the agency rated fewer than 10 Hong Kong corporates at present but planned to put far greater emphasis on these ratings in the future.

'We will be putting more effort into this and increasing our ratings team as we do expect intermediation to continue and bond markets to develop quite strongly in the future,' he said.

Raymond Yung, partner in charge of the financial services industry group for Arthur Andersen, said the lack of ratings was a key hurdle for Hong Kong corporates wishing to go to the primary capital markets to issue debt.

Phil Strause, regional director of Deloitte Consulting's financial services practice, said investment banks had long ago 'disintermediated' commercial banks in the United States.

'If you look at where many of the commercial banks in the US are, it is not in lending money to the large corporates - the growth areas have been in retail business and lending to small and medium-sized enterprises,' Mr Strause said.

If that trend were translated to the Hong Kong market it would result in the heavyweight corporate borrowers turning increasingly to capital markets for funding and away from banks, once demand for finance picked up, he said.



Bond appeal threat to bank-loan market