Offshore investor interest has recently picked up for Vietnam government bonds (VGBs) due to the fact that they offer an attractive yield, favourable tax treatment, limited foreign exchange (FX) risks (at least for the foreseeable future) as well as modest access costs.
Nevertheless, given a lack of secondary market liquidity, investments in VGBs should be considered on a buy-and-hold basis with potential FX risks medium-term. We believe that five-year VGBs offer a combination of attractive yields and moderate FX risks, although upcoming supply of state-owned and/or government guaranteed bonds, such as Agribank, could offer higher yields around 10 per cent.

VGBs offer high yields, favourable tax treatment
We believe that the main attractions of Vietnam government bonds are:
+ The high nominal yields on offer from 7.7 per cent (indicative one-year VGB yield) to 9.06 per cent (indicative 15-year VGB yield), which are the second highest in East Asia after Indonesia.
+ Favourable tax treatment: Vietnamese bonds are only subject to a 0.1 per cent tax on coupon payments + principal on every coupon payment day as well as 0.1 per cent on the sales proceeds.
+ Vietnamese dong (VND) stability: over the past few years, VND depreciation (which is subject to a managed float regime) has slowed to only 0.8 per cent per annum in since 2004.
+ Reasonable access costs: typical structuring costs (as offered by HSBC) on Total Return Swaps are Libor+10bp and 30 cents upfront, which lowers effective yields by approximately only 15bp per annum.
+ Modest supply: VGBs are auctioned on a weekly basis in typical auction sizes of VND200-VND500 billion ($12-$30 million) with total issuance amounting to VND1,945 trillion in 2005 (or $1.23 billion equivalent). Most of this issuance can be absorbed by the local banking system, which is flush with liquidity, with bank reserves and deposits increasing by VND20,426 billion and VND167,692 billion respectively in the 12-month period up to March 2006. In addition, quantitative monetary tightening by the State Bank of Vietnam has sharply decreased domestic credit growth below the rate of deposit growth, though domestic credit growth is still running at very high levels (+28.7 per cent year-on-year as of March 2006).
+ Declining yields: since July, VGB issuance yields, which are set administratively by the Ministry of Finance have declined until August. Their subsequent rise can be explained by attempts by: a) liquidity flush local banks to move up the yield by underbidding, b) traditional liquidity tightness in the local banking system close to year-end due to end-of-year corporate borrowing, c) the government’s decision to harmonise the coupons on its Treasury bonds and those on the government guaranteed Vietnam Development Bank (BIDV) at 8.40 per cent (from 8.75 per cent on BIDV bonds previously), d) competing bond issues with higher yields (eg: VND3 trillion in tier-2 capital issuance by state-owned Agribank offering yields up to 10 per cent). However, the trend towards rising yields seems to have come to an end with the five-year VGB yield auctioned at 8.4 per cent year-on-year on October 16, mainly as a result of offshore investor interest, although the seven-year VGB again attracted lacklustre demand (as on October 3).
+ Falling inflation spells an end to SBV tightening: our economist expects inflation to fall from 7.5 per cent in 2006 to 6.6 per cent in 2007 on average on the back of lower oil prices. As headline inflation will then run below GDP growth (HSBC forecast: 7.6 per cent in 2006, 7.3 per cent in 2007), this should pave the way for SBV easing given that SBV aims to keep inflation below the rate of GDP growth.
+ Improving fundamentals: finally, Vietnam’s entry to WTO should encourage further FDI inflows into the country from 2007, which should be complemented by an easing of foreign equity portfolio ownership limits to 49 per cent of shares outstanding. In turn, this should improve the structure of Vietnam’s economy, trend growth rate of GDP as well as improve the country’s overall balance of payments position (see below; for further information on Vietnam’s economic outlook please see Vietnam: Going for the next level published in September 2006 by HSBC’s Economics Team).

Illiquidity, flat yield curve - main drawbacks
On the flip-side, VGBs suffer from a few drawbacks as well:
+ Lack of liquidity: given their small issuance size, the MoF’s practice to issue new VGBs (mainly five-year tenors) at every weekly auction and with VGBs generally held on a buy-and-hold basis by local banks and insurance companies, secondary market liquidity of VGBs is almost non-existent, although the MOF is planning to start issuance of VGBs through re-openings from January 2007 onwards.
+ VND stability to continue? The main implication of the latter is that investments in VGBs should for now largely be considered on a buy-and-hold basis - in turn, exposing the investor to USD/VND risks during the holding period until maturity. It should thereby be noted that the high rate of headline inflation and the limited trend of VND depreciation implies a continual appreciation of the VND in real, inflation-adjusted terms, while Vietnam’s FX reserves are modest (around three months import coverage). That being said, the IMF - in its latest 2005 Article IV Consultation that ‘there is no evidence of significant exchange rate misalignment’, which appears to be corroborated by the sharply higher growth rate of exports (+22.4 per cent year-on-year in Q1 06) than imports (2.8 per cent year-on-year). FDI inflows, too, should contribute to Vietnam’s export performance and limit a rapid appreciation of the VND in real, productivity-adjusted terms. Finally, it should be noted that Vietnam’s current account deficit (-1.8 per cent of GDP in 2006) is offset by strong inflows of FDI, portfolio capital and foreign worker remittances ($2.2 billion in 2004), much of which accumulates in the local banking system rather than the State Bank of Vietnam.
+ Flat yield curve: given these potential FX risks, we believe that VGBs with maturities longer than five years offer limited attractiveness given the flat primary issuance curve (eg: seven-year VGBs are issued at only 17bp higher yields).
+ Competing issuance: separately, competing issuance - such as VND3 trillion in tier-2 capital issuance by state-owned Agribank offering yields up to 10 per cent - may also be more attractive compared to current issuance yields of VGBs. In addition, significant further issuance can be expected until 2010 to fund investment spending, including further development of Vietnam’s infrastructure needs.
In this respect, the government targets total social investment of VND2,200 trillion (2005 prices, $160 billion in current prices) over 2006-2010, or 40 per cent of GDP, which will require significant further issuance of Vietnamese bonds (at least VND110 trillion annually), among which by the Development Bank of Vietnam and the Electricity of Vietnam (EVN).
Against this backdrop, we believe that five-year VGBs are attractive to foreign investors on a buy-and-hold basis, although foreign investors should be cognisant of the FX risks involved on a medium-term basis (eg: beyond the next two-three years). In addition, we see greater attractiveness in upcoming issuance at higher yields by Agribank and other state-owned entities given the likely higher yields on offer.

Source: Vietnam Investment Review