Flows from banks raise China bond market risks

A huge wave of investment outsourcing by Chinese banks is creating a lot of new bond fund business – but also raising challenges – for domestic asset managers, even as equity funds and money market funds (MMFs) have lost their attraction.

Commercial banks have been handing large sums to asset managers, as low yields on government bonds leave them struggling to meet guaranteed returns on proprietary funds and wealth management products (WMPs) they sold to retail investors, as reported yesterday.

This is good news in the short term for asset managers, particularly amid general industry stagnation. Chinese bond funds’ assets under management grew 129% year on year to Rmb1.15 trillion ($116 billion) as of September.

Stretching capabilities

But the sheer volume of money being outsourced is likely to stretch fund houses' capabilities, particularly in riskier bonds.

“It will test many fund firms’ internal risk controls; that’s why some managers do not aim to grow such business aggressively,” said a Shanghai-based executive at a joint-venture asset manager.

Meanwhile, Alexandre Werno (pictured left), executive vice general manager at Fortune SG Fund in Shanghai, said: “Fund managers have needed to offer tailor-made services and products, get organised for RFPs [requests for proposals] and get appropriate reporting [standards], so it will push them to be more institutionalised.”

Institutional assets are growing swiftly as a percentage of fund manager business. Institutional clients accounted for 74% of the unit shares of bond funds in June, up from 59% a year ago, according to consultancy Z-Ben Advisors in Shanghai.

Bond fund managers said these institutional clients are demanding, which is pushing the fund houses to improve their level of service.

Gou Chenchen, head of fixed income at Pengyang Asset Management in Beijing, said: “Learning from the experience of the US fund industry, fund managers will need to enhance their bond investment capability after receiving a huge amount of mandates, and to improve research capabilities.”

However, this is in fact unlikely to herald a big improvement in investing standards among China’s bond fund managers. The fund houses seem to be acting more like a conduit for banks to access certain types of risky credits that they don’t know how to invest in by themselves.

“The [tailor-made bond fund] businesses share a similarity with their subsidiaries: huge volume but low margin,” said Liu Shichen, an analyst at Z-Ben.

Liquidity fears

This trend is also leading to a potentially bigger problem: moves by the banks to invest in riskier debt via fund managers raise issues around liquidity and risk control.

Rachel Wang, Morningstar’s director for manager research in Shenzhen, said commercial banks tended to have similar risk preferences on investments and were likely to have collective purchases and redemptions. This will increase bond market risks, if banks decide to redeem most of their assets all at once, she added.

The situation could be exacerbated by rising levels of onshore credit default risk, which could eventually create higher volatility in onshore bonds and potentially spark mass exits and volatility. 

That’s a concern, particularly given that banks are eager for exposure to riskier bonds. While mainland banks traditionally invest in bonds issued by government or policy financial institutions, they are also accessing the exchange-traded bond market, in which 48% of outstanding securities are higher-yielding corporate bonds. Rating agency Fitch estimates that 20% of onshore domestic bonds are held by bank WMPs and that bonds account for 56% of their assets.

Moreover, Pengyang’s Gou sees the limited ability to hedge credit in the immature mainland bond market is an added risk, particularly if outsourcing exposure is concentrated in certain types of credits.

China’s fund industry had similar fears when MMFs boomed after the success of Alibaba-backed YuEBao product two years ago.

Watchdog on the lookout 

A huge amount of liquidity moved from Chinese household savings into MMFs in search of yield, and industry participants feared that such products would run out of liquidity if investors redeemed en masse in a short period. So far, no such liquidity crisis has happened, but the China Securities Regulatory Commission issued new rules on MMF investment and liquidity requirements in December 2015.

The CSRC is also watching the fund industry’s liquidity closely, as its AUM booms. On November 18, the Asset Management Association of China asked managers to conduct stress tests on mutual fund products every quarter.

With asset growth raising the spectre of concentrated risk in corporate bonds, observers believe banks must reconsider the fervour with which they outsource to fund houses – and particularly the incentives that asset managers have to take risk.

“Third-party mandates usually charge performance fees, so managers have a higher incentive to take higher risks,” said Jack Yuan, Shanghai-based associate director at Fitch.

And it would not take much – perhaps a few bond defaults – to cause huge asset flight. China’s banks may have outsourced their investment risk, but that doesn’t mean they aren’t exposed to it.