Issues With Innovative New China Bond ETF

November 17, 2014

An alluring new bond ETF focused on China’s mainland credit market comes with a few caveats.

This year, Nov. 11 brought U.S. investors not only Veterans Day and a bond market holiday, but a groundbreaking innovation in the form of a new bond ETF focused on China’s mainland debt market. But with new ideas come new challenges. I’ll explain, but first the undeniably good news.

Market Vectors launched a first-of-its-kind onshore China bond fund, the ChinaAMC China Bond ETF (CBON), offering U.S. investors direct access to China’s onshore debt market in a way that was never possible before.

Here are the nuts and bolts: CBON has an annual expense ratio of 50 basis points, or $50 for each $10,000 invested. It’s a portfolio that invests in a broad range of government and quasi-government securities, and investment-grade credits denominated in China’s currency—the renminbi—excluding securitized debts.

CBON’s underlying index only selects credits rated AAA by at least one of the local credit rating agencies. The fund has a yield-to-maturity of 3.9 percent and a duration of 3.23 years.

This is good news, especially for investors hunting for yield. CBON has a perfectly sound investment thesis. But there are a few nuances and risks you should consider before jumping in and pursuing that 3.9 percent yield with seemingly little duration and credit risk.

Market Access & Tracking Risk

To cut to the chase, I’m skeptical of CBON’s ability to track its underlying benchmark tightly and consistently. Beyond the typical issues caused by liquidity constraints and different pricing sources in a bond fund, CBON faces a major structural hurdle: It currently doesn’t have access to China’s interbank bond market.

China’s bond market is segmented into two major markets: the interbank market, and the exchange-traded market. According to a 2014 research report by Standard Chartered, about 93 percent of bonds outstanding are traded in the interbank market, which is only accessible to authorized institutional participants.

Current regulation requires each asset management plan—each fund, really—to register a separate account at the People’s Bank of China to participate in the interbank market. According to CBON’s prospectus, the fund currently doesn’t have such an account. As such, the fund can only hold exchange-traded bonds for now.

To put it simply, CBON can’t currently access many of the bonds in its underlying index, which includes both interbank and exchange-traded bonds. This limitation poses a structural hurdle for the fund to sample its index, which has a possible implication.

This access limitation may drive a wedge between the index and the fund, and depending on market conditions, CBON can underperform or outperform its benchmark. However, since 50 percent of its index comprises corporate bonds that are traded only on exchanges, CBON’s inability to access the interbank market will have material, but limited, impact on its tracking performance.

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