US ETFs to take aim at China's onshore bond market

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U.S. investment firms are readying the first line of exchange-traded funds designed to give American investors access to China's swelling onshore bond market, which has been largely closed off to foreigners.

At least four fund managers - Deutsche Bank AG, Global X Funds, KraneShares and Van Eck Global - have outlined plans to launch China onshore bond ETFs, according to company filings with the U.S. Securities and Exchange Commission. The first of the funds could launch as early as this month, sources familiar with the matter say. 

Some of the funds will invest in a range of yuan assets, including government and corporate bonds, while others will be more specialized, focusing on commercial paper, for example. They will be targeted at both institutional and retail investors.

Gaining access is no small thing for investors. The government-related bond market is about $3 trillion (18.4 trillion yuan) and China's domestic corporate bond market has grown to about $1.5 trillion (9 trillion yuan) at the end of August, after companies raised a combined $261 billion (1.6 trillion yuan) from bond issuance in the first eight months of the year. In June, credit agency Standard & Poor's said the Chinese corporate bond market overtook the United States as the world's biggest and is now set to soak up a third of global company debt needs over the next five years.

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While onshore Chinese bonds carry the currency, default and regulatory risks that might be expected in a fledgling market, their relatively high yields and low correlation to U.S. Treasuries and other global fixed-income and equities markets will make them appealing to investors, analysts say.

"Yield levels are attractive," said Cecilia Chan, chief investment officer of fixed income for the Asia Pacific region at HSBC Global Asset Management, in a telephone interview. She expects U.S. and European investors to look to China for yields they can't get in their own regions.

Ten-year yields on Chinese government bonds are hovering around 4 percent, compared to about 2.3 percent in the United States and Britain. If, as some investors expect, the Chinese economy slows further, then the value of high-yielding bonds will likely be bolstered as interest rates fall.

"The ability to be able to access that market, either by retail or institutional investors, is very appealing," said Bruno del Ama, chief executive officer of New York-based Global X Funds, because the burgeoning market has historically been out of reach for foreigners, even big investors. As the market expands and China relaxes its tight control over onshore assets, more investors may want to take part, he said.

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Limitations, risk

Nevertheless, headwinds still exist.

For starters, there's the government-run quota system which limits foreign access to China's onshore market. Only about $108 billion (662.2 billion yuan) had been approved for foreign investment in the mainland's securities markets, including stocks and bonds, under the country's Renminbi Qualified Foreign Institutional Investor (RQFII) and Qualified Foreign Institutional Investor (QFII) programs, by the end of September.

To access those onshore bonds, U.S. fund issuers will have to partner with approved asset managers, mainly based in Hong Kong, and could find their supplies limited.

The operational complexity of these ETFs is in part reflected in the higher fees they are expected to demand. The KraneShares fund, for example, will charge 0.68 percent in annual management fees, while the Global X fund is expected to cost 0.65 percent in annual management fees. Deutsche and Van Eck Global have not yet disclosed fees.

By comparison, the PowerShares Chinese Yuan Dim Sum Bond fund, which invests in offshore bonds, has an annual management fee of 0.45 percent.

"Accessibility is definitely on the top of the list" of challenges, said Dennis Hudachek, a senior analyst with research firm who is predicting strong investor demand for the comparatively high-yielding bonds. He pointed out that several onshore equity exchange-traded funds have already run up against their allocated quota this year.

While, the lack of defaults in the Chinese corporate debt market is comforting for investors, it can add to uncertainty because of the possibility of shocks when the authorities do eventually allow more defaults. Bondholder protections have yet to be fully tested.

"It's quite like a belief, like a religion, how much bonds are protected by the government," said HSBC's Chan, referring to both government and corporate domestic bonds.

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Chan says, investors would like to see more defaults in minor issues "to watch how the default process is handled and look for the market to re-price the probability of default, especially for the low-credit quality bonds."

In March, solar equipment producer Chaori produced the first onshore default when it missed an interest payment, and analysts had expected the precedent-setting default might force a re-pricing of credit risk in a market that long assumed even high-yielding debt carried an implicit state guarantee. Moody's at the time noted that regulators' higher tolerance for corporate bond defaults would be in line with the Chinese government's "shift to adopt more market-oriented policies."

But earlier this week, Chaori announced that nine domestic companies would step in to restructure the debt, along with a guarantee from state-owned China Great Wall Asset Management and a Shanghai-based investment firm to help repay bondholders.

Finally, there is currency risk as well. Only one of the KraneShares funds has explicitly said it will hedge currency, while the other funds in their filings do not indicate currency hedging and warn of the currency risks. The firms declined to comment on the specifics of the filings, as is typical before a fund's launch. While the yuan has been appreciating for years against the dollar, gaining 2.9 percent in 2013, it has shed 1.5 percent so far in 2014.

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Better than Dim Sum

China's onshore market is a better reflection of the Chinese economy than so called "dim sum bonds" that are issued offshore, said del Ama. That offshore market can include debt issued by international companies such as fast food chain McDonald's Corp or heavy equipment maker Caterpillar, so long as it is denominated in renminbi.

A couple of ETFs offer access to the dim sum market, but none to date access the onshore market.

The Global X filing indicates its fund will invest in a broad range of onshore bonds, including government and corporates, which are yielding in a range of 5 to 6 percent, depending on maturity and ratings. The Deutsche and Market Vectors filings indicate a similar broad composition.

KraneShares, a New York-based boutique asset manager focused on investing in China, is planning funds that will focus specifically on onshore commercial paper, which KraneShares Managing Director Brendan Ahern said offers yields of around 4.7 percent and access to utility companies, among the main issuers of commercial paper in China.