The Hong Kong dollar bond market is expected to get a boost and increase in importance as asset owners, particularly insurers, begin to prepare their portfolios to comply with new requirements based on risk-based capital (RBC) management.
The implementation of the RBC means Hong Kong insurers will have to build their Hong Kong dollar (HKD)-denominated portfolios, thus pushing demand for HKD bonds and other fixed income assets.
“There’s an opportunity here in the sense that you will see a natural demand growing for Hong Kong dollar assets given the regulatory changes in the future,” says Benjamin Rudd, chief investment officer of Prudential Hong Kong.
The Insurance Authority (IA) in Hong Kong is currently developing its capital framework toward an RBC regime that is consistent with the principles issued by the International Association of Insurance Supervisors (IAIS). The RBC framework is expected to substantially change the capital framework set from the Hong Kong Insurance Ordinance.
This development comes as the future of the HKD bond market faces some uncertainty in the wake of the obvious preference of investors and issuers for US dollar bonds because of their relative attractiveness vis-à-vis HKD bonds.
Since the Hong Kong dollar is pegged to the US dollar, the HKD bond performance is linked to the US treasury market and US monetary policy. The US Federal Reserve reduced its benchmark funds rate by 25 basis points to a range of 1.5% to 1.75% at the end of October as part of efforts to slow down the deterioration of the US economy.
“The US interest rate scenario is very important when we manage our Hong Kong dollar bond portfolio. Basically, we look at the relative value between the HK dollar bond and US dollar bond market. We compare their yield pick-up and also analyze the future market outlook. Until recently, the HK dollar rate has been trading below the US dollar simply because of the strong liquidity in the HK dollar market as well as the excessive net demand. There’s not enough bond supply in Hong Kong,” says Cecilia Chan, chief investment officer, fixed income Asia-Pacific, HSBC Global Asset Management.
Historically, the HK dollar is not particularly attractive in terms of relative value when compared to the US dollar although with recent political developments in Hong Kong, HK dollar interest rates have moved up with money market rates and swap rates becoming more attractive across the board.
The HK dollar’s three-month forward points, an indicator of liquidity conditions in the foreign-exchange market, has soared to the highest level since September 1999 last week.
The three-month forward points climbed to 138, while the spot rate lost 0.03% to 7.8295 per greenback as of 8:32 a.m. on Friday (November 15). The three-month interbank borrowing costs of the Hong Kong dollar are 46 basis points higher than the equivalent interest rates on the greenback. However, this is considered to be a blip in the curve and the long-term prospects for the HK dollar remain unchanged.
Despite its lackadaisical prospects, HKD bonds offer asset owners and institutional investors who possess HKD liabilities opportunities for liability matching to enhance the risk management of their portfolios.
“For asset owners and investors who have HKD liabilities, they are likely to invest in HKD bonds on a “buy and hold” basis for liability matching. On the other hand, the active investment managers would be more opportunistic, focus on the relative value and future volatility analysis when investing in the Hong Kong dollar bond market,” Chan says.
The HKD bond’s desirability as a liability-matching asset will feed into the reforms being implemented by the insurance industry which will push insurers to beef up their local currency or HKD assets.
“Going forward, there will be structural changes in the industry in terms of demand for assets in the local currency or HK dollar bond market particularly among insurance peers,” Rudd says.
“Because of this expected increase in demand, there would be a more urgent need to address the lack of supply in HKD bonds, as well as to improve the diversification of the market and expand the maturities,” Rudd adds.