Issues With Innovative New China Bond ETF

November 17, 2014

Beyond tracking risk, investors also need to consider credit risk. Typically, to get higher yield, investors have to reach further down the credit spectrum.

But as I noted, CBON only holds government debts and AAA credits rated by at least one of the local credit rating agencies. It’s a portfolio that in theory offers little to no credit risk, yet it’s serving up a juicy 3.9 percent yield. That’s practically unheard of in today’s global bond markets.

It begs the question, can you really trust those local rating agencies?

I’d say yes. Cautiously so.

Bond Ratings, The Inside Scoop

The reality is that China doesn’t allow foreign credit rating agencies to operate directly in mainland China. Many of the established local rating agencies are founded as joint ventures with the “big three” (S&P, Moody’s, and Fitch) from the U.S. It’s not ideal, but as such, these local rating agencies should have everything they need to maintain a rigorous and robust rating system.

Many of these local rating agencies have been around for decades and are highly reputable. As China is liberalizing its financial market and attracting foreign capital, it has every incentive to keep the credit rating system honest and reliable.

However, I’m hard-wired to be skeptical of just about everything that comes from mainland China.

Additionally, according to the same 2014 Standard Chartered report, “onshore credit ratings are heavily skewed towards the high side, and most bonds were issued with few covenants.” Therefore, my suggestion is that when it comes to credit rating—and the risk involved with those ratings—taking the data with a grain of salt might be wise.

Market-access risk and data-quality risk are common concerns in accessing China’s investment markets. If nothing else, these uncertainties speak to a core truth in investing: It rewards those who see the potential and are willing to take the risk when others won’t.

CBON is a first-of-a-kind strategy that is breaking new ground, but it might not be the only game in town for long. Deutsche Bank, KraneShares and Global X have all filed plans to launch onshore China bond ETFs as well.

At the time this article was written, the author held no positions in any securities mentioned in the article. Contact Howard Lee at [email protected]

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