Issues With Innovative New China Bond ETF

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.

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]