China Bond ETFs in Focus on Recent Market Turmoil - ETF News And Commentary

Concerns about the health of the Chinese economy have cropped up again after being pushed to the back burner for a while during the second half of 2013. Weaker-than-expected industrial production numbers, soft retail sales and exports are some of the signs of slowdown in the world's second largest economy. Moreover, the government's growth target of 7.5% this year would be the slowest since 1990 (read: China ETFs Slump on Terrible Export Numbers).

Along with the sluggish economy, the Chinese bond market is witnessing slower growth after almost a decade. In the past ten years, the number of new issues rose by almost 80-fold. Sales outside of auctions slipped 10% to 3.77 trillion yuan in 2013, after rising 56% in 2012 and 48% in 2011, according to a Bloomberg report.

Among other factors, the increasing number of defaults in the nation's bond market is believed to be the primary cause for the current debacle in the Chinese bond market (read: Inside the Recent China A Shares ETF Slump).

Most recently, a Chinese developer, Zhejiang Xingrun Real Estate Co., collapsed with 3.5 billion yuan of outstanding debt. This collapse comes less than two weeks after Shanghai Chaori Energy Science & Technology Co. became the first onshore bond issuer to default in Chinese history.

Growing Concerns?

The recent default is more severe and is expected to be a big dampener to the country's booming property market. Zhejiang is in fact China's largest property developer.

Earlier, bonds and most credit products were considered almost “riskless” as they were thought to be backed by the government and state-owned banks in case of a default. China had managed to avert a high profile default of an investment product ahead of their New Year.

China's bond market has been a significant fund-raising source for the nation's small and mid-sized companies. This market came into prominence ever since the Chinese banks tightened their lending policies in the wake of the 2008 global financial crisis. Bank credit is only available to large enterprises.

However, the rising number of defaults has shaken investor confidence in the Chinese bond market and consequently new bond issues have begun to slump. The $4.2 trillion Chinese onshore bond market is expected to face more credit risk as businesses default on their payments and the economy slows down further. A higher number of defaults are expected to push corporate financing costs higher cover credit risks.  

This situation has also hit the ETFs catering to the Chinese bond market. These products are all trading in the red in the year-to-date time frame. Below, we have highlighted two Chinese bond ETFs in greater detail that might face volatile trading ahead (see all the Emerging Market Bond ETFs here):

Chinese Yuan Dim Sum Bond Portfolio DSUM

Though the fund delivered a modest return of 2.57% in 2013, DSUM has lost around 3.39% in the past one month and is down 2.94% since the start of the year. 

DSUM manages an asset base of $207.8 million and seeks to provide exposure to Chinese Renminbi RMB-denominated bonds. The fund tracks the performance of the Citi Custom Dim Sum (Offshore CNY) Bond Index.
 
The index holds RMB-denominated bonds issued by governments, agencies, supranationals and corporations, excluding synthetics, convertible bonds, retail bonds and CDs. As such, the fund holds 122 Chinese bonds which are quite well diversified.
 
Investors should also note that roughly 36% of the fund is rated at least ‘A' by S&P while another 45% isn't rated at all (read: 3 Emerging Market ETFs Off to a Great Start in 2014).
 
Market Vectors Renminbi Bond ETF (CHLC)
 
CHLC tracks the Market Vectors Renminbi Bond Index (MVCHLC) and manages a small asset base of $5.16 million. This benchmark looks to give exposure to Chinese Renminbi-denominated bonds that are investable to market participants outside Mainland China
 
Unlike DSUM, CHLC holds a small basket of 23 bonds and is somewhat concentrated in its top 5 holdings. The top holding – Germany's Bosch – alone has 9.5% allocation in the fund.          
 
Also, the fund has more global exposure compared to DSUM, as it invests 63.1% in China. Germany, Malaysia and the U.K. are some of the other countries having exposure in the fund.
 
CHLC has lost 1.39% in the past one month, after returning a modest 2.09% in 2013.

Bottom Line

The recent defaults are defeating China's very intention of expanding the size of its bond market.  Chinese policymakers intend to boost direct financing such as bonds and stocks. If the number of defaults continues, investors would probably be less interested in funding these high-risk notes and thus the aforementioned ETFs might see more volatility in the weeks ahead.

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