China joins Hong Kong to mainland
Allowing mainland Chinese investors access to Hong Kong-listed stocks has put China’s convertibles bonds firmly in the spotlight.
- Chinese regulators have now allowed mainland investors to invest in Chinese companies listed in Hong Kong. This will create great demand for Chinese Convertible Bonds.
- Shares listed on China's 'A-Share' market currently trade at a premium of around 126 per cent over their 'H-Share' counterparts.
- Thanks to their bond component, Chinese Convertibles offer investors lower-risk participation in the Hong Kong market.
- While a number of state-owned 'Red-Chip' companies offer attractive Convertible Bond issues, it will be a challenge to build meaningful positions without the benefit of significant trading resources.
Thanks to a recent change in government policy, China’s ‘H-share’ market, which consists of just over 180 Chinese companies whose shares are traded on the Hong Kong exchange and denominated in HK dollars, is undergoing something of a revolution. Following new guidelines from the China Securities Regulatory Commission, fund managers based onshore in China can now invest in Chinese companies listed in Hong Kong via the Shanghai-HK Stock Connect (SHSC) or ‘southbound link’.
Mere expectations of likely future demand from mutual fund managers triggered a sudden deluge of new investment from the mainland in April, which fuelled a vigorous rally.
Waiting in the wings
There is currently around €184 billion in Chinese equity mutual funds1. With Chinese mainland investors having been previously constrained to investing in shares listed on China’s ‘A-share’ market, these stocks are still trading at a premium of around 126 per cent over their ‘H-share’ counterparts2. Although this premium contracted during April, it has since rebounded to be up by around a third over the course of the last year.
This presents an attractive opportunity to buy dual-listed stocks and to benefit as the H-share discount erodes. In the case of H-shares that are not dual listed, the broader opportunity to access some of China’s better quality listed stocks in sectors that are not well represented in the A-share market will also appeal to investors, especially while the discount remains prominent.
However, the Hong Kong market has always been volatile and with a spate of Chinese IPOs shortly expected, liquidity has recently been withdrawn while the market shows signs of consolidating.
Those convertible bonds that are linked to Hong Kong-listed stocks are likely to be especially sought after as their bond component means they offer lower-risk participation in a volatile market.
The premiums on such convertibles are already high as they include a number of China’s sector leaders and companies with stronger fundamentals than their A-share counterparts. We were quick to adjust our positioning following April’s sharp rally as we were overweight in both of the top-performing issues – Hong Kong Exchanges which gained over 60 per cent during the month and Fosun International, China’s largest privately-owned conglomerate, which rose more than 30 per cent. Having taken profits on these we are now looking to build larger positions in a number of other Chinese convertibles.
The only major convertible to be linked to a Hong Kong-listed stock that trades at a discount to its A-share counterpart is China Unicom – the state-owned telecom operator. The convertible is likely to remain a target thanks to speculation over a potential merger with China Telecom. However, with only around six months to maturity, the bond’s delta will remain volatile.
Feeling the flow
Elsewhere, stocks in ‘hot’ sectors that are not well represented in the A-share market – such as environmental protection, semiconductors and software – are also natural targets. This includes the likes of SMIC, ENN Energy, Kingsoft, Kingdee and Shanghai Industrial. The first of these is the largest and most advanced semiconductor foundry in China at a time when quality semiconductor businesses are thin on the ground in the A-share market. For reasons of national security, China is anxious to control the whole of its semiconductor supply chain.
Consequently, the chipmaker enjoys government support in the form of JV funding from the Chinese provinces where it builds its new plants. Even so, its shares still trade at a big discount to the lower-quality stocks in the A-share market. And thanks to recent profit-taking by investors, its performance has lagged of late, despite its obvious appeal to mainland investors.
We also like the prospects of ENN Energy, China’s largest privately-owned gas distribution business, whose shares still sit at a small discount to their A-share listed peers. We think the stock remains underrated, especially given its environmental credentials.
This year China introduced stringent new legislation promising greater powers to environmental authorities and harsher punishments for polluters. China currently burns almost as much coal as the rest of the world combined, so natural gas, which produces half as much carbon dioxide, is likely to be a popular target for mainland investors.
We’re also monitoring one of our existing holdings – Shanghai Industrial. This state-owned property and toll road business still trades at a discount to its book value as the market has yet to recognise the value of the progress it has made in its water and solar business.
The year of trading carefully
With the prospect of increasing mainland fund flows and the promise of a new Shenzhen-HK Stock Connect (SZSC) later this year, which could expand investors’ access to shares in smaller Hong Kong quoted companies, there’s no shortage of opportunities in Chinese convertibles.
However, with demand set to rise steeply in the year ahead, gaining worthwhile access to many of these issues at a viable price is likely to be the biggest challenge for convertible investors.
1 Source: Deutsche Bank Convertible Bonds 4 May 2015
2 Source: Based on the Hang Seng China AH Premium Index of dual-listed stocks as at 15 May 2015