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Hedge funds enticed by higher yields in the Far East

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By Joe McGrath – Returns from the low end of investment grade debt are doing nothing to excite investors, so hedge funds are looking to higher yields … in China.

Investors seeking a higher yielding income source are flocking to China and the country’s high yield bond market is booming. 

High yield is characterised by loans with a non-investment grade credit rating, which is typically BBB or below from Standard & Poors, or below BAA from Moody’s. According to a Bloomberg report citing AJ Securities data, China had some GBP130 billion (RMB1.1 trillion) of local company bonds with a coupon of 8 per cent or more by the end of May 2019.

For investors, the Chinese high yield market offers the opportunity to tap into a lucrative higher income source at a time when many believe Western corporate bonds, particularly at the bottom of the investment grade spectrum, are no longer paying sufficient amounts for the risk of holding them.

In June, Kshitij Sinha, a fixed income fund manager at Canada Life Investments stated that BBB-rated corporate bonds were now “close to fair value” adding that the “risk reward in owning one is skewed more to the downside given the macroeconomic backdrop.”

Sinha explained that massive growth in the number of BBB-rated bonds has been a result of quantitative easing and the unusually long period of time that interest rates have been low, which has seen companies borrow substantially at favourable rates.

In an interview with Hedgeweek, Philippe Ferreira, a senior strategist at Lyxor Asset Management, says he has concerns about the returns on offer for bonds at the bottom end of the lower investment grade spectrum.

“I don’t believe that investments are adequately remunerated for the risks that they take at the moment,” he explains. “There is now a common understanding that you are not remunerated for the risks, but you have limited options. If you want to generate returns, you need to take risks, and, for many managers this means taking more risks that you are perhaps comfortable with.”

Risky business

For those investors who believe that investment grade bonds are no longer worth the risk, shuffling up the risk curve seems a logical step and China, it seems, is awash with choice. 

The Chinese government has done a lot to stimulate demand in recent years. Having imposed capital controls to prevent Chinese entities from taking resources out of the country, it then accelerated the opening up of its financial system to foreign investors through the Hong Kong Bond Connect trading initiative.

Bond Connect gives foreign investors access to China’s interbank bond market through Hong Kong and replaces the previous process which was laborious and slow. There is a similar link between Hong Kong and the mainland for equity investors, called Stock Connect.

“It is much easier to trade local fixed income instruments,” explains Graham Stock, senior sovereign strategist at BlueBay Asset Management. 

“Previously, there was a process in place to give access, but it was painfully slow. We spent three or four years setting up local custody and sending the necessary documents required. All of a sudden, this alternative channel opened up and access became much easier.”

Lyxor’s Ferreira agrees, explaining that the opening up of the Chinese market is capturing the imagination of hedge funds, due to the size and maturity of the market.

“You have options to enter the market as it is not very mature,” he explains. “There is a premium for the early investors. We still don’t see many managers deploying capital in China, just the most experienced ones. We see interest, but not so much capital being deployed.”

Ferreira says that being early to embrace the opportunity set, though, could solve some of the headaches for those looking to improve on the yields being offered at the lower end of the investment grade market. 

“The market is not that mature, so you have more arbitrage opportunities. Investors are looking for yields and pockets of inefficiency, so want to be among the first to enter the market.”

Experience counts

The caution exercised by Western investors in dipping their toe into Chinese high yield for the first time is understandable, say those who are more familiar with this market. 

“When you invest in a market that you are not familiar with, there is a lot of due diligence work that needs to be done,” says Gordon Ip, chief investment officer, fixed income at Hong Kong-based Value Partners.

“For global managers, especially those in the West, because of cultural differences, market structure and the type of market participant in Asian markets, they really have to adopt a local mindset. They need to fully understand the dynamics of this market and the type of issuer, so you need to hire local.”

Value Partners have been operating in the Chinese bond market for many years and considers it familiar territory. Ip agrees that some parts of the high yield market could deliver better risk-rated-returns for investors, but only if they take the time to understand local sensitivities.

“You need to understand when a news piece hits the market, the local language sometimes can be very different. It poses a very interesting challenge for a lot of western managers,” he says.

“I am quite constructive on Chinese high yield right now and in particular, Chinese property credit. it is one sector that will be insulated from any trade war. The property sector is one sector that accounts for around a third of Chinese GDP calculations. 

“We do not believe that the government is willing to sacrifice that. We believe the volatility in that sector will be quite low. It is supported by the urbanisation theme, the growing middle class and it is paying a high yield.”

Bluebay’s Graham Stock, agrees with Ip’s assessment, saying that real estate, in particular, is a theme which holds huge potential.

“In the high yield space, there is quite a lot in real estate which taps into one of the areas growing particularly fast in China – anything that is on the fringes of the infrastructure push is obviously appealing. 

“It seems to me that we get two or three new issues out of China in both investment grade or high yield every day. We might not want to participate in all those deals, but every so often there is something that is good value.”

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