Foreign investors retreat from yuan bonds as dollar premium shrinks

SHANGHAI, July 30 (Reuters) - The U.S. dollar's narrowing premium over the yuan in the forwards market has dampened foreign interest in Chinese bonds, despite recent gains in the Chinese currency.

WHY IT'S IMPORTANT

Foreign investors had steadily accumulated yuan bonds since late 2023. A popular trading strategy involved purchasing short-term yuan-denominated bank debt through currency-hedged swaps, which offered higher yields exceeding those of U.S. Treasuries.

However, rising implied yuan rates, reflected in the forwards market, eroded those gains and made such yuan debt less appealing. One-year swaps CNY1Y= hovered near the highest level since October.

BY THE NUMBERS

Foreign investors sold China's onshore yuan bonds for the second consecutive month in June. Notably, they offloaded a net 73 billion yuan ($10.18 billion) worth of negotiable certificates of deposits (NCDs), a short-term debt instrument in the interbank market, accounting for over 60% of total outflows last month.

One-year yuan forwards were quoted at 6.9982 per dollar versus a spot rate of 7.1767 on Wednesday, allowing investors to swap dollars for yuan at an implied yield of about 2.48%. The currency swap mechanism shields investors from yuan fluctuations CNY=CFXS.

Using the yuan acquired from the swap market to invest in a one-year NCD AAANCD1Y=CFXS will fetch a combined return of about 4.1%, roughly the same as yields from Treasuries US1YT=RR. Previously, the strategy could book an extra yield of about 90 basis points versus the Treasuries.

CONTEXT

Rising implied yuan rates come amid easing yuan depreciation pressure. As a result, major state-owned banks are feeling less urgency to acquire dollars via swaps to defend the yuan in the spot market.

Previously, state banks were seen swapping yuan for dollars in the forwards market and selling those dollars in the spot market to prop up a weakening yuan, sources told Reuters.

KEY QUOTES

** Goldman Sachs

"The rise in back-end USD/CNY forward points hints at a potential unwind of banks' dollar short positions accumulated over the past year, which should help buffer appreciation pressures."

** OCBC

"The NCD outflows had been expected as asset swap pick-up narrowed further during the month and NCD maturity was heavy ... But for a quick and strong comeback of inflows, U.S.-China yield differentials probably need to narrow from here."

($1 = 7.1744 Chinese yuan)