How Dim Sum Bonds Will Change the World

It's easy to think of bonds as innocuous instruments of debt that only the most uptight of accountants could get even remotely excited about. Yet this perception is completely wrong, as the breadth and depth of the U.S. bond market is an important source of our hegemonic position in the world.

The benefits associated with this formidable market are referred to derisively abroad as America's "exorbitant privilege" -- a term first coined by Valery Giscard d'Estaing, the French minister of finance under Charles de Gaulle. In short, this privilege refers to our ability to borrow cheaply and without limit in U.S. dollars. For the astute observer, it's one of the reasons that Treasury bond yields seemed immune from the otherwise pernicious effects of last year's ratings downgrade.

It's my contention, however, that all of this will soon change. And the primary agent of change is Hong Kong's dim sum bond market -- a small but aggressively expanding alternative to the bond markets in the West. I would even go so far as to say that the growth of this market is the single most important economic event of our times, as it both portends and catalyzes the ongoing Eastward transition of financial might. For the enterprising investor looking to get rich, in turn, coming to terms with this transition is not simply important, it's imperative.

The inception and growth of a market
Dim sum bonds are commercial and government bonds issued in Hong Kong but denominated in Chinese renminbi rather than the local currency, the Hong Kong dollar. For three years after the market's inception in 2007, these bonds were originally the province of only the Chinese government and its financial institutions, such as the China Development Bank, which issued the first of such bonds in July of that year.

While stringent capital controls kept a lid on the market's growth, deregulation in July 2010 led to the development of an offshore market in renminbi and the internationalization of dim sum bonds. That month, the Chinese government gave foreign, nonfinancial companies the right to issue renminbi-denominated bonds outside of China's otherwise closed capital markets.

The first company to take advantage of this was none other than McDonald's (NYS: MCD) , which raised 200 million yuan in three-year bonds just one month later. Its reason for doing so? Dim sum bonds offered cheap financing compared to the interest rates charged by Chinese banks at the time. According to McDonald's corporate controller in China, the company's borrowing costs on the mainland were around 7%, whereas its first dim sum bond had a coupon rate of just 3%.

Given the success of McDonald's maiden journey, other foreign nonfinancial companies were encouraged to follow its lead. Companies like Volkswagen AG and Caterpillar (NYS: CAT) , for example, floated bond issues soon thereafter to finance their burgeoning operations on the mainland. And at the end of last year, it was even announced that Agincourt Capital plans to raise the equivalent of $500 million in yuan to finance the purchase of property in Australia. If consummated, this would be the first secured convertible renminbi bond where funds will be invested outside of China.

The promise and perils of early adoption
The dim sum market has grown markedly since its inception in 2007. About 160 billion yuan, or about $25 billion, of dim sum debt was sold in the first 10 months of 2011. By comparison, some 35.7 billion yuan of dim sum bonds were sold in 2010, and only 16 billion yuan of the bonds were sold in 2009. Furthermore, analysts at Deutsche Bank (NYS: DB) believe dim sum issuances could reach 240 billion yuan this year.

Yet an estimate of the market's current size -- at about 185 billion yuan, or $29 billion -- reveals that it's still effectively a rounding error when compared to America's $36 trillion bond market. This disparity makes it particularly susceptible to market swings affecting both yields and liquidity. The uncertainty in capital markets last September, for example, caused the yield on Chinese government dim sum bonds to rise from 0.6% in August to around 1.5% by the middle of November. And daily trading volume at the time dropped to 50 million yuan from an earlier peak of 500 million yuan.

Given the dim sum market's massive potential, however, a number of big players have nevertheless waded into its choppy waters. They include Guggenheim Funds' Guggenheim Yuan Bond ETF (NYS: RMB) , Invesco's PowerShares Chinese Dim Sum Bond Portfolio, and Van Eck Global's Market Vectors Renminbi Bond ETF. All three are traded in the U.S. and have $5 million to $6 million in assets. In addition, fund powerhouse BlackRock (NYS: BLK) launched its first dim sum bond mutual fund in November 2011, targeting qualified investors mainly in Asia. It has about 190 million yuan in renminbi assets under management, according to The Wall Street Journal.

Making sense of it all
Let there be no mistake about it, the fledgling dim sum market still has a long way to go before it's on par with comparable markets in the West and Japan. But if it is successful, and I believe it will be, then it will change the world as we know it. Not only will it facilitate the internationalization of the yuan, as I've discussed before, but it will also offer both individual and sovereign investors an alternative to government bonds issued by the United States, Europe, and Japan. The likely net result will be higher relative yields in the West.

For you the investor, in turn, there are two takeaways. The first and immediate one is that you can now gain direct exposure to China's currency via the dim sum market through the three exchange-traded funds mentioned above. And the second, albeit less tangible, takeaway is that the shifting onus of global financial power catalyzed by this market is something that you should exploit by diversifying at least a portion of your portfolio into emerging markets like China's.

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At the time thisarticle was published Foolish contributing writer John Maxfield does not have a financial position in any of the companies mentioned above. Motley Fool newsletter services have recommended buying shares of BlackRock and McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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