Mordy: DSUM Bucks Bond Trend

November 19, 2013

Fund focused on bonds issued outside of China is up while most global bond markets stumble.

This article is part of a regular series of thought-leadership pieces from some of the more-influential ETF strategists in the money management industry. Today’s article features Tyler Mordy, president and co-chief investment strategist of Toronto-based Hahn Investment Stewards.

Hollywood built a baseball diamond in a remote Iowa cornfield as a set for Phil Robinson’s 1989 drama, “Field of Dreams.” It remains there to this day, attracting more than 50,000 visitors each year.

A similarly obscure construction is developing in the financial world. This time, the venue is not Dubuque County, Iowa, but rather, China’s offshore bond market. This other building project will lead us to an already-existing ETF, the PowerShares Chinese Yuan Dim Sum Bond fund (DSUM | C), which cultivates a different field of dreams in the Middle Kingdom.

That said, some scene-setting will be helpful.

Consider that China’s economy is only half the size of the United States, and it’s the world’s largest export nation. Yet the majority of China’s trade flows are transacted in dollars (China’s currency, the yuan, ranks only eighth in world trade).¹ In fact, most emerging-market trade finance is invoiced in dollars (USD).

This paradigm presents a problem for China and its trade partners. During periods when dollar funding tightens, crises can easily erupt. The late-1990s Asian crisis is history’s most notable example (when unsustainable debts were amassed in foreign currency and liquidity faded).

But even as recently as this past summer, when the Bernanke Fed started “talking taper,” emerging markets—especially ones with large current account deficits—fell dramatically.

Clearly, the above currency system is not ideal. This is becoming more apparent as China increasingly integrates its supply chains with the rest of Asia and moves toward “near-sourcing” commodities and other tradable goods. Bilateral trade is soaring between China and the Southeast Asian bloc, reaching a new high of $400.9 billion in 2012, up 10.2 percent from 2011.²

An Expanded Bond Menu

As the wider emerging markets industrialize and move toward a more stable macroeconomic regime, a retreat from dollar dependence will be necessary. The obvious alternative is the yuan or, as It’s referred to more formally, the renminbi (RMB).

China, above all, knows this. That is why internationalizing the RMB has become such a politically pressing issue. But how will this be accomplished? If a happy story is to unfold, then the plot must include two key protagonists: a stable currency and reliable bond market.

Enter “dim sum” bonds. These are sovereign and corporate bonds issued outside of China but denominated in RMB. Western multinationals, like Ford, Volkswagen and Caterpillar, have tapped the market to raise capital.

Why would issuers do this? In short, to match revenues and liabilities, thereby hedging their foreign exchange risk.


Companies that can reliably issue bonds for capital spending and working capital will more likely transact trade in RMB. Central banks can also either invest or raise funds in RMB, allowing them to manage their balance of payment accounts.

At this stage, the dim sum bond market is still nascent and small—totaling only about $80 billion. However, its success and stability is of enormous importance to China’s strategy of globalizing its currency.

Case For The Renminbi

With little fanfare, China’s currency has appreciated steadily since it started to float in 2005. Since then, the RMB has never had a losing year versus the dollar.

To understand whether this will continue, one must examine China compared with other global currencies. The value of fiat money, after all, is currently a relative beauty contest, and underlying currency drivers extend far beyond national borders.

Viewed in this context, the bar has never been lower for RMB appreciation. Consider that experimental—even reckless—monetary policy has become de rigueur for central banks. Policy mandates have been enlarged and an ostensible liberation from traditional institutional shackles has been granted.

This is most evident in the West’s leading central banks. Messrs. Bernanke, Draghi and Kuroda are deliberately setting out to seed a small inflation. The risk is that they overplant.

China also knows this. Therefore, its push to expedite RMB internationalization comes with a tacit recognition that currency strength will likely follow. However, the alternative is a continuing dependence on USD funding and trade settlement, and, consequently, unnecessary economic volatility.

The above scenario has historical precedent. In the early 1970s, America was following a path of rampant currency debasement and monetary recklessness. Inflation-phobic Germany recognized this and successfully internationalized the deutsche mark.

This development served Europe well, as it became less dependent on U.S. liquidity; reduced its macroeconomic volatility; and attracted global asset allocators to the German bund.

To make this work, Germany needed to support a sound monetary policy and strong currency. China must do the same.³

DSUM For Defense

It’s been a sharp and—some would say—well-deserved bear market in fixed income this year. Pundits have been falling over themselves to recommend zero bond exposure in portfolios.

We understand this revulsion. After all, who wants to lend to indebted governments determined to depreciate their currency?

Still, there are hazards that accompany this recommendation. Bonds have always been an anchor to portfolios in times of stress. Over the long term, that is unlikely to change.

This is why the Chinese bond market is so encouraging. While almost every global bond market has delivered negative returns this year, dim sum bonds are actually up 4.2 percent year-to-date (as of Q3 2013 and measured by DSUM).

What’s more, these returns have been delivered with higher yields, lower volatility and low correlation (DSUM’s three-year correlation to the iShares Core S&P 500 ETF (IVV | A-99) is 0.31—read: noncorrelated!).


Yield Of Dreams?

To be sure, the RMB and dim sum bonds are not a one-way bet. This year, with wider emerging market risk aversion, issuance has been driven by Chinese financials and not Western corporations (which arguably carry better credit quality). And, of course, China’s economic success is not guaranteed.

The above risks are valid. Deep skepticism remains large. And China’s growth is finally slowing. Its average annual GDP growth rate was 10 percent from 2002 through 2011. That era is now over.

Growth will almost surely moderate as a consequence of economic rebalancing (as investment declines as a share of GDP, from a very high level), reduced scope for productivity gains (as incomes rise and the pool of cheap labor from rural areas dries up) and demographic changes (as the country’s labor force peaks).

Yet calling for China’s collapse is overhyped. What is collapsing is China’s former neo-mercantilist economy of selling cheap goods to the West.

The new economy is focused on industrial upgrading and increased domestic consumption. This transition will require a move away from a reliance on U.S. funding and settlement. Recent figures are encouraging. In 2010, only 3 percent of China’s trade was transacted in renminbi. Last year, that figure had risen to more than 15 percent.

Conclusion: Go The Distance

This is our first article in what will be a longer-running series. It may seem strange that we have chosen dim sum bonds—an esoteric part of the investing universe—as our opening shot.

But this topic precisely gets to the heart of macro ETF investing. It isn’t about trading the latest hot stock. It’s about spotting big-picture trends—anticipating the next “field of dreams”—before they emerge into the mainstream.

The great promise of building ETF portfolios this way is broader diversification, better risk management and not remaining hostage to traditionally rigid asset-allocation approaches, which have fared poorly in recent years.

ETF strategists understand this. We may not be hearing voices from dead baseball players, but we are earnestly building structures for a better way of investing.

It’s early days, but investors are already showing up.


¹Data according to SWIFT

²Jakarta Post, “Renminbi towards internationalization,” Nov. 4, 2013

³See GaveKal Research, “Our Currency and Your Problem,” Sept. 26, 2012

Tyler Mordy, president and co-chief investment officer of Hahn Investment Stewards, is a recognized innovator in the design and application of global macro ETF managed portfolios. He is widely interviewed by the financial media for his global investment strategy views, as well as ETF trends. CNBC has called him one of the “best independent ETF experts.”

Contact Tyler at [email protected]


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