Buyers Guide to RMB Bonds Main author: Bryan Collins
RMB bond investors need to do their homework first The RMB bond market is a relatively new and exciting investment opportunity, with RMB bond having grown in popularity and number over the past one-to-two years. The growth to date has been impressive but sorting through the issues affecting the asset class and understanding the risks is becoming increasingly challenging. This guide aims to outline the key investment strategies on offer in the market and provides some suggestions as to the questions investors need to ask when selecting a fund. As always, investment goals vary, so seeking independent financial advice is recommended before making any investment decision. 2
There are three main types of RMB bond Dim Sum RMB hedged Onshore RMB The dim sum market refers to RMB-denominated and settled issued offshore. Dim sum invest mostly in these securities but may have some ability to invest in non- RMB denominated bonds that are then hedged back to RMB. Typically invest in USD-denominated bonds and are fully hedged back to RMB. They may not actually hold any dim sum bonds and can hold bonds of varying credit quality (high yield, investment grade, government, convertible bonds, CNY synthetic bonds) and can include securities from various countries, not necessarily Chinese or Asian issuers. In this group we can also include bond of any kind that happen to have a fully hedged RMB share class. RQFII 1 or QFII use the developing Chinese quota system by accessing the onshore Chinese bond or equity markets almost exclusively. Although the onshore Chinese market is large, it remains relatively undeveloped, so understanding credit quality, interest rate risk and liquidity is very important with these. Most onshore invest exclusively in Chinese issuers as very few multinational corporations (MNCs) are able to issue in that market, whereas offshore dim sum and RMB-hedged (i.e. those not using a QFII or RQFII quota) may invest in Chinese, Asian or other multinational issuers more familiar to offshore investors. 1. The Renminbi Qualified Foreign Institutional Investor (RQFII) scheme permits qualified investors to channel offshore RMB into mainland bond and stock markets. It follows the Qualified Foreign Institutional Investor (QFII) scheme, which was introduced in 2002 and principally designed to allow licensed foreign investors to buy and sell RMB denominated A shares in China s mainland stock exchanges. These quotas are limited in size, subject to change and the manager s ability to repatriate back offshore can be impaired in certain circumstances. 3
Points to note What s important to note, as you may have noticed, is that not all RMB bond carry the same risks, despite having similar names. Currency: While they may all offer exposure to the RMB currency, there are several ways to get exposure to the currency including directly onshore, via CNH (offshore RMB) or by using currency forwards for hedging (including CNH deliverable and nondeliverable CNY forwards). Credit quality: Funds will also vary greatly in terms of credit quality, some invest heavily in high yield bonds, others may focus on investment grade and the underlying interest rate risks will vary too. Onshore are essentially exposed to Chinese inflationary and interest rate risks, while offshore RMB hedged may have more implicit exposure to US interest rate risk if they are buying USD denominated bonds and hedging them back to RMB. Dim sum are more aligned to onshore Chinese interest rates but remain somewhat independent. However given the dim sum market is a relatively short duration market at this stage, duration risk is typically low and more dependent on underlying credit risk. 4
So what should you be asking when selecting a fund? Here are some key questions that we think are important when trying to gauge the risks and opportunities of various types of and deciding which is right for you. These questions are also worth considering when reviewing a fund after a period of time, as fund strategies can change a concept known as style-shift or -drift Questions to Ask: 1. What is the fund s goal or objective? Is it income, capital gain or both? Risks attached to bond vary and with higher potential returns, comes higher risk. 2. What is the fund s investment strategy? The fund should have a clearly-stated strategy, so that it can be easily categorized as one of the 3 fund types above and the investor can start to gauge risk. You should also ask whether the fund has any limits on credit quality -- in other words, does the fund buy investment grade or high yield bonds or both and in what combination. High yield is a common component of many RMB bond but that exposure carries much higher risks than investment grade government or corporate bonds, so investors must pay particular attention in this case. 3. What are the main risks of investing in the fund? Understanding risk is critical to being an informed investor. Markets can go up and down, and you can make or lose money in any investment, so understanding how a fund may react when markets are weak as well as strong, is also important. Also, given that the RMB bond market is new, we have yet to see a full credit cycle, so this aspect can be challenging. Also keep in mind that past performance is no indicator of what will happen in the future, and given some have flexible strategies, risks within a fund may have changed significantly. To help gauge risks we suggest investors break it down as follows: credit risk, interest rate risk and liquidity risk, and others. For example: interest rate risk: the risk that the value of an investment will fall as interest rates rise. This is closely related to inflation risk - the risk that the value of an investment will be eroded as inflation rates rise (eg. cash is typically low risk but often does not deliver a return at or above the rate of inflation. A fund s duration will help here a larger duration means more sensitivity to rising yields. credit risk: the risk that an obligation will not be paid and this is much higher with more leveraged companies that issue high yield bonds. liquidity risk: the risk that a manager will not be able to buy or sell an investment quickly because buying and selling opportunities are limited and/or expensive. currency risk: the risk that the fund will lose value due to fluctuations in the rate of exchange, namely that the RMB depreciates in value against the USD, EUR or your base currency. political risk: the risk that a foreign investment will lose value due to unfavourable political or regulatory changes in that country, including changes to the convertibility of the RMB or availability of RMB offshore. 4. What are the fund s fees and expenses? Management fees may not include all costs. Upfront or other ongoing advisor or distributor fees may need to be included. All managers should be able to tell you this and will include this information in the offering documents or prospectus. How readily can I buy and sell the fund s shares or units? Many are priced daily allowing you to buy and sell readily, others may be only available once a week or month. For that price daily, some may also not price during special holiday periods, such as Chinese New Year, whereas others may still be open. 5. How are the fund s distributions determined? If the fund pays a distribution you should know whether it is paid based on the underlying income generated by the bonds it holds or whether the distribution is sometimes supplemented by paying out any capital gains (or losses) generated. Also ask whether any FX hedging gains are used to supplement income, because this may increase or decrease income as well as the value of the investment if the RMB moves against other currencies. 6. What information is available about the fund? Ask for regular updates, top holdings, information on portfolio concentration, yield to maturity (YTM) as well as distribution yield (running yield), the fund's duration (interest rate sensitivity), number of issuers as well as the number of securities and ask for the average credit rating and breakdown (if the fund has large exposures to non-rated bonds, these are often of lower quality, so the manager should be able to give you an equivalent rating). Knowing the number of issuers and securities is important to evaluate concentration risk, as all other things equal, fewer names and concentrated exposure results in higher risk. 7. What s the investment horizon? A relatively simple question to ask but where the answer will invariably depend on your own investment goals. In general, the riskier the fund, the longer the investment horizon should be to weather any volatility. 8. How do I benchmark performance? It is always important to measure return given the underlying risks. This may not always mean how has the fund performed against an index but also how has it performed against other of similar risk. While there are now many indices to compare, they, just like the various RMB bond fund strategies, vary significantly and so may not always provide a definitive comparison, but they do help understand differences in return and volatility. As a good rule of thumb, first get comfortable with the investment strategy and risks. In summary: If something sounds too good to be true, it probably is. 5
Table Some onshore RMB bond have drawn attention to the superior yields on offer versus Dim Sum bonds currently, but investors should gauge the full risk/return profile of a fund before investing. We list the key differences below: Offshore/CNH RMB bond market Onshore/CNY RMB bond market CNH RMB deposits Market size RMB360 billion RMB22042 billion RMB448 billion Issuer composition China, Hong Kong and overseas corporates China Mostly state-owned enterprises (SOE) related Sector 59% corporates 41% treasury bonds, central bank notes and policy bank bonds 26% corporates 74% government Some banks and financial institutions Deposits protected by the Deposit Protection Scheme, with a compensation limit n/a Number of issuers >100 <200 n/a Number of securities >150 >3000 n/a Daily liquidity Yes Yes No Redemption Penalty No No Penalty: forfeit interest and incur administration fee Yield 3-5% 3-5% Variable, with higher rates mainly for promotional periods Duration 2-3 years 4-5 years n/a Accessibilities Requires no quotas Requires a QFII or RQFII quota Subject to RMB conversion limit for HK residents Rating agencies International rating agencies e.g. S&P, Moody s, Fitch, etc. Local rating agencies n/a Credit rating composition Rated: 65% Mostly unrated by international rating agencies n/a Unrated: 35% Transparency High Low High Tax No withholding tax Withholding tax on interest income No tax Governing law HK, UK, US and Europe PRC HK Source: FIL Limited, Citi Research, September 2012; HKMA, Hong Kong Deposit Protection Board, January 2013 Please note RMB is not freely convertible and is subject to exchange control imposed by the Chinese government. There is no assurance that RMB will not be subject to devaluation. RMB debt securities and bank deposits are typically unsecured debt obligations not supported by any collateral, which are generally subject to a higher credit risk. FIL Limited and its subsidiaries are commonly referred to as Fidelity or Fidelity Worldwide Investment. Fidelity only gives information about its products and services. Any person considering an investment should seek independent advice on the suitability or otherwise of the particular investment. Investment involves risks. Past performance is not indicative of future performance. Please refer to the Fidelity Prospectus for Hong Kong Investors for further information including the risk factors. If investment returns are not denominated in HKD or USD, US/HK dollar based investors are exposed to exchange rate fluctuations. Fidelity, Fidelity Worldwide Investment, the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited. The material is issued by FIL Investment Management (Hong Kong) Limited and it has not been reviewed by the Securities and Futures Commission ( SFC ). 6