Bourse Link Drives Five-Month Convertibles Rally: China Credit

China’s convertible bonds are extending the longest rally since 2009 before next month’s linking of the Hong Kong and Shanghai stock markets. Investors say the debt is a relatively safer bet on an economic recovery.

The S&P China Convertible Bond Index rose 8.4 percent in the five months through August, while the nation’s corporate bond index gained 2.9 percent. The yield on Ping An Insurance Group Co.’s 0.8 percent notes due November 2019 slid 211 basis points to 0.66 percent. The shares traded at 43.3 yuan in Shanghai today, compared with a conversion price of 40.88.

The Shanghai Composite Index of equities has rebounded 14 percent from this year’s low reached March 12 on the prospect of policy makers accelerating monetary easing and liberalizing financial markets in the world’s second-largest economy. Because the principal on convertible debt is repaid unless there is a default, they allow investors to limit losses in China’s volatile equity markets while profiting from any growth revival, according to Schroder Investment Management Ltd.

“We increased Chinese convertible holdings quite significantly in the second quarter,” said Dorian Carrell, a Singapore-based fund manager at Schroder which helped oversee $8.5 billion of debt in Asia as of end-June. “The through-train should drive up China equities and convertibles to some extent. They also benefit from the fact that international investor sentiment toward China has improved.”

China Inflows

Brokerages in Hong Kong and Shanghai said the first full trial of the cities’ exchange link went smoothly last weekend, supporting plans to go live in October with a program giving foreigners unprecedented access to mainland stocks. The connect will allow a net 23.5 billion yuan ($3.8 billion) of daily trading between Asia’s biggest stock markets after Japan.

The Shanghai Composite Index rose 0.6 percent to a 15-month high of 2,289.13 today, while Hong Kong’s Hang Seng Index advanced 1.3 percent to 25,077, near a six-year high.

“The link will continue to be one of the main drivers for convertibles to outperform over the next quarter,” said Dong Dezhi, a Guosen Securities Co. strategist in Shanghai who picked debt in Ping An Insurance and China Petroleum & Chemical Corp. as the best bets. “The government is likely to step up support to sustain growth. Current pessimism over the outlook may dissipate.”

Policy Stimulus

China’s manufacturing growth was slower than estimated last month, joining credit, production and investment data in suggesting the economy is losing momentum. The official Purchasing Managers’ Index was at 51.1 for August, missing the

51.2 median estimate in a Bloomberg survey. It remained above 50, indicating expansion. The broadest measure of new credit was

273.1 billion yuan in July, the lowest since the global financial crisis, central bank data showed Aug. 13.

Speculation of more stimulus sent the one-year interest-rate swap sliding 66 basis points to 3.61 percent today from a three-month high of 4.27 percent touched July 18, according to data compiled by Bloomberg. The yield on five-year sovereign bonds has advanced 13 basis points this quarter to 3.97 percent yesterday. The yuan rose 1 percent from June 30 to 6.1455 per dollar in Shanghai today.

The People’s Bank of China has granted a 20 billion yuan re-lending quota to some regional bank branches to support agriculture, according to a statement on the monetary authority’s website last week. It will cut re-lending interest rates for some rural financial institutions in poor areas.

Limited Supply

Another factor adding to the allure of convertible bonds is limited supply, according to Qin Han, a Beijing-based bond analyst at Guotai Junan Securities Co. Issuance reached $1.8 billion in the first eight months of this year, compared with 2013’s total of $8.9 billion, according to data compiled by Bloomberg. About $5.6 billion was sold in the second six months of last year, the data showed.

“New supply in the second half may be about half the total of a year ago while demand is rising in anticipation of an equity rally,” Guotai’s Qin said by phone yesterday. China’s annual party congress in October “will likely accelerate reforms in state-owned enterprises, allowing another rally in equities and convertibles.”

Improving Sentiment

Guotai Junan favors securities sold by Ping An Insurance, Bank of China Ltd. and China Petroleum & Chemical Corp., Qin said. The yield on Bank of China’s 1.7 percent convertible bonds due June 2016 slumped 317 basis points this year to 1.93 percent, Shanghai exchange data show.

There are signs that global investor sentiment toward China is improving. The CSOP FTSE China A50 Exchange-Traded Fund recorded an inflow of HK$3.78 billion in August, after an unprecedented HK$8.47 billion in July. The iShares China Large-Cap ETF, the largest Chinese exchange-traded fund in the U.S., attracted a net $518 million in August, the biggest monthly inflow since December 2012’s $1.34 billion.

The nation’s non-manufacturing PMI rose to 54.4 from a six-month low of 54.2 in July, official figures showed today in Beijing. A separate services gauge from HSBC Holdings Plc and Markit Economics surged to 54.1 from 50.

The Shanghai index is valued at 8 times 12-month projected earnings, compared with the five-year average multiple of 11.1, according to data compiled by Bloomberg. The Shanghai index may double in the next two years as the bourse link fuels capital inflows, Mark Matthews, Singapore-based head of Asia research at Bank Julius Baer & Co., told Bloomberg Television on Aug. 28.

“A lot of yuan convertible bond issues are highly equity sensitive, so they would benefit from that, although it will take a while for the plumbing and rules for the link to be sorted out,” Schroder’s Carrell said. “Valuation anomalies should be eradicated between the exchanges. China is the least unattractive alternative among emerging markets because of perceived policy loosening in order to meet its growth target.”