After an unruly sell-off at the end of last year, calm appears to have returned to the offshore renminbi market.

Dim sum bonds and other debt products denominated in the Chinese currency have rallied in recent weeks as investors became more optimistic about the outlook for the small but fast-growing market in Hong Kong.

Yet, as bondholders learned to their cost last autumn, the offshore renminbi bond market is volatile and illiquid. The question now is whether dim sum bond yields are high enough to compensate for the risks.

Over the past six months, yields have surged. Five-year Chinese government bonds, for example, now yield about 1.8 per cent, up from 1.2 per cent in August. Corporate bond yields have jumped more substantially.

In some cases, the bonds look like bargains. Take Volkswagen, the German automaker. Its renminbi-denominated bonds due 2016 are yielding about 3 per cent. By comparison, its euro-denominated bonds due in 2015 and 2019 both yield below 2 per cent.

For investors who expect the renminbi to appreciate against the euro, VW’s dim sum bonds represent a compelling proposition. The only drawbacks are that renminbi bonds are much less liquid than euro or dollar ones, the asset class is untested, and the flow of renminbi in or out of the offshore market could shift dramatically depending on regulatory decisions by Beijing.

There are other reasons to be cautious. While dim sum bond yields are much higher than they were a year ago, they are still much lower than bond yields on the Chinese mainland. For example, five-year Chinese government bonds traded in Shanghai yield about 3.2 per cent, compared with just 1.8 per cent in Hong Kong.

Over the long term, offshore yields are likely to converge with onshore ones, says Li Cui, economist for Asia at RBS. “As Chinese interest rates are higher, more investment opportunities in the onshore markets will tend to move up the offshore rates.”

But in the short and medium term, the picture is more complicated. While Beijing has in recent years expanded the channels through which renminbi can flow between the onshore and offshore markets, China’s capital account remains mostly closed. That means the scope for arbitrage between the two markets is still limited, so rates can vary substantially.

Indeed, on average, offshore renminbi bond yields have not moved in line with onshore yields. In fact, they have moved in opposite directions. “The offshore rates are much more closely related to the international rates such as the US dollar Libor,” says Ms Cui.

Whatever happens to interest rates in other markets, the most pressing challenge facing the dim sum market is the fact that a third of outstanding dim sum bonds, or Rmb80bn of a total Rmb244bn ($38.6bn), are coming due by end 2012.

“The refinancing environment,” says Becky Liu, credit strategist at HSBC, “has become increasingly challenging.”

Some 85 per cent of all renminbi debt products in Hong Kong have a tenor below three years, says Ms Liu. That means there will be a steady supply of debt that needs to be refinanced until 2014, particularly in the coming months.

An increasing number of new issuers is also coming to the dim sum market to raise funds.

Lanxess, the German speciality chemicals company, priced its debut dim sum bond on Wednesday. The three-year deal came in at 3.95 per cent, raising Rmb500m ($79m). And last week, America Movil, the telecoms company controlled by Mexican billionaire Carlos Slim, raised Rmb1bn ($160m) at a yield of 3.5 per cent.

Frances Cheung, strategist at Crédit Agricole, estimates that companies will issue a total of Rmb200bn ($31bn) this year, with “risk to the upside”. The combination of heavy bond supply with tight renminbi liquidity will cause dim sum bond yields to grind higher over the year, she reckons. Three-year Chinese government bond yields will rise by as much as 80 basis points, or 0.8 percentage points, by the end of 2012, according to her forecasts.

Indeed, as more groups like Lanxess and America Movil tap the offshore renminbi market for funds, liquidity will become more scarce, putting further pressure on yields to rise. The offshore renminbi deposit pool is already shrinking in size as funds flow back to the Chinese mainland. Total renminbi deposits in Hong Kong declined by a record amount in December, falling 6.2 per cent from the previous month, to Rmb588bn ($93bn).

The wildcard for investors is what happens to the renminbi’s exchange rate. If, as was the case for most of last year, investors expect the renminbi to appreciate sharply against the US dollar, then they will pile into dim sum bonds, driving yields lower.

But if investors continue to think the renminbi will barely move against the dollar, or if they contemplate depreciation, then demand for renminbi-denominated assets will be lacklustre unless yields rise further.

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