Climbing the Chinese wall of money

Investors have flocked into renminbi-denominated bond funds in hopes of an
appreciation. But as the market matures, the currency will play a secondary
role, selectors suggest.

The offshore bonds denominated in renminbi, the currency of mainland China, and issued in Hong Kong – so-called Dim Sum bonds – have been a remarkable success story to date.

Attracting billions in foreign capital, chief financial officers from global companies to Chinese firms and investors particularly from Asia and Europe have used the step-bystep liberalisation of the currency to benefit from local funding possibilities not seen in China due to its closed capital account.

This has happened on the back of the program launched in 2010 to internationalise the Chinese currency. According to Swift, the financial transactions firm, the renminbi (RMB) recently overtook the Swiss franc as a global payments currency. Indeed, bond funds investing in the Chinese currency have flourished as yields in the US and Europe remain meager. European investors such as Matthias Metzger hope for longer term appreciation of the currency.

“The renminbi still is the least volatile of all emerging market currencies and we view the appreciation potential as intact,” says the Swiss-based fund adviser to the Berenberg Renminbi Bond Opportunities Funds.

Recently however, these expectations were shaken as the RMB experienced a depreciation of 1% over the course of just four days. In any other currency market investors could not care less about such a minor change. However, RMB investors have become used to the exceptionally low volatility and the steady appreciation over the past five years.

Still, Metzger sees it as “strategic diversification” for portfolios. The recent currency weakness “has not changed the investment case. China has the largest currency reserves in the world, a high savings rate of 40%, overall still relatively low levels of debt and a growing middle class,” he says.

Weijun Yin, product specialist at Allianz Global Investors, reminds investors that the People’s Bank of China – which sets the value of the currency – had three reasons for the recent depreciation: “First, to manage investors’ expectations in relation to the RMB’s one-way appreciation bet. Second, to curb hot money inflows and third, paving the way for a further widening in the RMB trading band.”

This widening took effect on 17 March, doubling the daily trading band of the currency to allow larger intraday swings of up to 2%.The recent depreciation might deter the “hot money” from a further influx into Hong Kong and mainland China. Fund flows have increased markedly and pushed up the spread between the onshore and the offshore RMB.

“This spread rose to a 12-month high in January,” notes Chen Long of the Hong-Kong-based research firm Gavekal in a recent note. This indicated that investors increasingly bet on the likelihood of an appreciation, with the PBoC “reining in” speculative money.

Friedrich Strasser, chief investment officer at the Austrian mutual fund firm Gutmann KAG, feels that “the small depreciation is hyped by media outlets.”

Yet, putting aside the issue of the RMB versus dollar rate,Strasser the recent announcement of the liberalisation of interest rates as a more important reason to invest in China than currency. “This means that financial markets in China are liberalised of government intervention, thus leaving more room to market forces.”

This will open opportunities for investors along the way, says Strasser. “The China story remains intact and with it the longer term appreciation, even as setbacks are possible.” Gutmann is planning to launch a RMB bond fund to
benefit from the growing importance of the currency. It is a “work in progress,” Strasser suggests about the fund. Adding to the recent opening up of the capital account, the Chinese bond market has evolved.

“This is not just a bet on an increasing RMB,” cautions Strasser. “This is a bond market evolving, with issuers ranging across the spectrum of credit quality and countries.” Thus, investors need to look “very closely” at the chosen strategy before evaluating a portfolio.

Recently, the spectre of Chinese bond defaults has rattled financial markets, as shadow banking products failed to pay interest or principal. For Strasser, defaults are a necessity. “The Chinese government is well aware that it needs to have defaults in order to improve the financial system.”

A more mature Chinese financial system might also change the way investors view the asset class. Recently Moody’s, the ratings agency, put out a research paper suggesting that issuance in the RMB market will remain particularly strong, even as volatility has crept into the currency.

“As the offshore RMB bond market becomes larger, with increasing diversity in terms of investors and issuers, the currency element will progressively fade out as the dominant factor,” its analysts noted.

Strasser agrees with the analysis: for him, the Chinese currency remains an attractive investment opportunity as issuers from developed economies and China alike raise funds in RMB and thus offer investors more chances to diversify.

According to Dealogic, the financial data provider, RMB bonds now stand at $1.5trn, marking a near-trebling of the market since 2011. Export-driven Germany has seen RMB issuance from firms such as Volkswagen and Daimler, while the Canadian Province of British Columbia became the first foreign government to issue bonds in the CNH market, and the IFC, the
financial arm of the World Bank, issued a Dim Sum bond in
London.

“Issuers in the offshore market tend to have higher credit quality with more transparent balance sheets and financials,” emphasizes Weijun Yin of Allianz.

The Gutmann strategy will add to an already flourishing offering of RMB focused funds in the German speaking market. Among them, two of the biggest asset managers, DWS and Allianz GI, have ventured into RMB funds. A look at 2013 fund flows for Germany reveals strong growth in the
asset class.

In their European Fund Market review Lipper analysts have shown that RMB bond funds made the top five domestic net asset flows in Germany. Indeed, as yields in the euro area and the US remain low and the fears about rising rates are going up in tandem, currency products in general attracted major domestic interest. What might have helped, says one selector, was also the “sudden weakness elsewhere”.

Depreciations occurred in a wide range of emerging markets, from India to South Africa to Brazil, as global capital flows cooled. China remains relatively insulated as its currency is still heavily regulated and set by the PBoC.

However, fund distributors suggest that it is retail and private banking interest that has driven the flows to date, with institutional investors not yet rushing to the asset class.

One reason might be that “this still is a very political market,” according to says Silvia Cova, head of Fund of Funds at the Austrian mutual fund firm Bawag PSK Invest. “Adding to that, the recent depreciation has clearly shown that the renminbi is not a one-way street.”

Yet she considers RMB funds as a possible diversifier, but thinks that investors need to have an opportunistic approach to the asset class.

InvestmentEurope has taken a look at some 30 different RMB bond funds that are available to German, Austrian and Swiss investors, according to Lipper data.

They reveal significant differences in strategy and risk. Both duration and credit risk is very different across the various products, increasing the need for in-depth selection. For instance, two of the largest funds – one from DWS, one from AllianceBernstein – vary significantly.

The average maturity of the bonds invested is twice as high for the Bernstein product, and the portion of bonds rated BBB or lower is also twice as high. Thus some of the bond funds can be seen as substitutes to high yield portfolios, while others have a money market sense to it with a currency twist. Yields to maturity can vary significantly around the level of four percent.

Metzger of Berenberg (Schweiz) AG emphasizes the need to diversify. The Berenberg Fund, whose subadviser in charge of the single bond selection is Goldman Sachs Asset Management in Singapore, invests only 15% in issuers from mainland China. At the same time more than a third of the issuers in the fund are global companies using the RMB market to diversify their funding.

“The bond component can add a lot of value beyond the mere appreciation potential of the currency,” says Metzger. Yin of Allianz also emphasises that investors need to look closely at the bond selection, as some sectors in the Chinese economy such as coal and solar have recently experienced hard times. “Companies with massive overcapacity and fragile cash flow will be naturally excluded,” Yin says about the selection process at AGI.

Even as fund managers and selectors thus focus increasingly on the bond side of the RMB trade, the currency will cast a cloud over the asset class in coming quarters. Authorities will make it clearer which path they prefer for the internationalisation of currency, and investors will need to listen closely.

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