With China’s economy creeping toward world’s largest is it time for more investors to invest some cash there?
Until recently, foreign entities investing cash in China was a topic mainly for MNCs and other direct investors who had trapped cash in the country. Short-duration liquidity funds were pioneered by a few bank asset managers (JP Morgan Asset Management being one of the first) to give their clients an alternative to bank deposits, which allowed them to pick up yield (thanks also to the income tax exemption on fund returns) while improving credit quality with a AAA-rated money fund.
But what about investing excess liquidity in China if you don’t have cash trapped cash there? While accelerating reforms of capital regulations may allow cash to be brought into China to invest onshore (and get it out again when needed), there would be far more takers if cash could be invested directly into the Chinese fixed-income market from offshore accounts.
Fortunately, there are a variety of RMB money funds that have sprung up to serve this market. Many have focused on off-shore RMB issues (e.g., dim sum bonds) or synthetically created RMB hedged funds that hedge back USD-issuances by Chinese or other entities which are much smaller and more expensive markets than the Chinese onshore market. Offshore funds investing in onshore bonds have been much more limited, in large part due to the restrictions that China imposes on offshore investor’s ability to invest onshore. The only way to invest onshore, as an offshore investor, is to have access to a Chinese government granted quota.
Get ready for RMB allocation pitch
The number of asset managers offering onshore access to offshore investors has started to take off since the Renminbi Qualified Foreign Institutional Investor (RQFII) program launched in November 2011. Initially the RQFII quota was granted only to approved affiliates of Chinese firms in Hong Kong, but it was expanded last year to Taipei, London and Singapore.
The RQFII program effectively opened up China’s restricted fixed income market to overseas investors and, for the first time, overseas investors gained access to China’s $6 trillion fixed-income market (third-largest in the world). The RQFII quota followed the 2002 launch of the country’s qualified foreign institutional investor (QFII) program, which is primarily an equity quota with more limited liquidity. As the RQFII has expanded, the number of asset managers applying to join has increased to 54 (including 8 international managers with the latest being BlackRock, which announced a $320mn allocation earlier this month) and continues to grow.
Also joining the fray of funds targeting offshore investors seeking to invest onshore, is a soon-to-be-launched RMB Income Fund, being offered to US institutional investors by Deer Isle Financial in association Bosera Funds, China’s fifth-largest fund-management company by assets under management ($30bn+) and the number two manager of corporate pension plans in China. Bosera was one of the first Chinese fund managers to have a fixed-income focus and, with this, develop an internationally rigorous in-house credit analysis method for a wide spectrum of Chinese credits, including corporate, local government and industrial issues.
The Deer Isle Bosera RMB Income fund will have a minimum 80 percent allocation to the onshore Chinese fixed income market through the Bosera RMB Bond Fund—which is an existing mutual fund that has RQFII quota allowing international investors access to the Chinese on-shore market with daily liquidity—and up to a 20 percent allocation to a portfolio of Dim Sum bonds. This gives the fund ample flexibility to invest in the most attractive Chinese issues on a risk-adjusted basis, whether they are issued on-shore or off-shore.
Based on the existing Bosera RMB Bond Fund and the pro-forma Dim Sum allocation performance, the fund’s average net annual return for the period from July 2012 (inception) through April 2014 was 4.61 percent with annualized volatility of 3.05 percent. This compares to the average returns of 2.10 percent (with 4.07 percent volatility) for the JPM Global Aggregate Index and 2.92 percent (with 4.24% volatility) for the Barclays Advanced EM Debt Index for the same period.
Like many fixed-income funds in China, recently, the Bosera fund has been shifting allocations to better credits with slightly longer average duration to pick up yield, as Chinese investors have flooded into short-term money market funds. Weighted average duration for the portfolio has gone from 1.10 at the end of March to 1.76 as of April 30, with average yield falling from 5 percent to 4.93 for that same period.
Does this yield pick-up warrant the risk of investing in China? Yes, it does, according to Dianna Raedle, CEO and Founder for Deer Isle. Her pitch deck lays out the reasons, and many of these will likely be seen in many other decks touting investment in RMB fixed income funds. The short-story is that investing in AA or better China-based fixed income funds offer high credit-risk adjusted returns, plus low correlation to developed market or EM fixed income, i.e., risk reducing portfolio diversification.
But the main point is that “if investors looked closely at China fundamentals, and left out the fact that they were from China, everyone would be establishing allocation for China now,” Ms. Raedle said. “Wouldn’t you want to invest in a market that is AA-rated, has the world’s second largest GDP (representing approximately one-third of all emerging market GDP), has accounted for about half of global GDP growth, represents the third-largest global bond market, represents the largest world’s trading nation with the second most used currency in global trade finance and has a sovereign default risk (per CDS) that is roughly the same as the US?”.
Unfortunately, the fact that it is China that creates the impression of additional risk. Some of this risk perception can be overcome with education regarding Chinese capital markets, reform efforts, and the impact of policies going forward. However, there is risk that reform efforts and Chinese policy responses might not succeed. The uncertainty surrounding the extent and timing of financial market deregulation may prevent investors from building a RMB allocation. In addition, access to quotas may limit allocation size.
A comparison of the new Deer Isle-offered Bosera fund with the most popular onshore liquidity fund offered by JPM Asset Management (see table below) shows that the Deer Isle Fund can be offered directly to offshore investors and has flexibility to invest in a wider variety of investments from both a credit and duration perspective giving the fund manager more ability to create alpha while the JPM fund is a pure on-shore money market product with greater emphasis on liquidity.
Early adopters wanted
Early adopters can take advantage of the excess return (based upon a hedged comparison to US Treasuries) that is currently available by investing in on-shore Chinese fixed income. This excess return is predominantly available due to the quota regime and is likely to be reduced as the quotas are increased or eventually disappear. Paradoxically, many investors may wait until Chinese fixed income is a well-accepted part of a diversified portfolio (based upon capital markets or GDP weighting) to make an investment and this will be the time that the quota based yield benefit will have disappeared.
It is clear that the quotas are being increased and as they are increased you will increasingly learn about Chinese fixed income opportunities as more asset managers have the ability to offer a fixed income product and have an incentive to educate the market about the opportunities as they have the ability to profit by offering a product. Indeed, on June 6, Reuters reported that SAFE had relaxed some of the restrictions on quotas by allowing institutions to allocate their quotas across RQFII funds. Before this, a quota application had to specify an allocation for each product and the RQFII would either waste the quota allocated to that fund if it was not met by investor demand or formally request permission for reallocation.
As access to these funds grows with more and more asset managers offering them, and fewer restrictions, the decision to allocate cash or pension assets to RMB-denominated assets will only become more topical. As with any such investments, the early yield advantage created by the quota restrictions will go to the bold investors who take the decision earlier. Waiting for everyone else to enter the market will let the regulatory arbitrage portion of the current yield opportunity slip away.