Wave of CB fund launches forecast for China

Fund management companies (FMCs) in China are eager to tap into renewed investor interest for convertible bonds on the back of a rush of fundraising by the nation’s two biggest banks.

Fullgoal is poised to launch a convertible bond (CB) fund on November 18, the second such product to be brought to the domestic market in the past month after Bosera FMC issued its CB offering on October 28.

This comes after a six-year hiatus. In May 2004, Aegon Industrial FMC sold China’s first CB fund, followed three months later by Hua An FMC, which launched a hybrid fund called Hua An Baoli Allocation with a remit to invest 10-70% of its assets into convertible bonds. These two funds have accumulatively yielded 296% and 349% since inception, respectively.

However, the market in China is so small for such hybrid securities that no similar fund products have been launched since.

But Bank of China (BoC) and Industrial and Commercial Bank of China (ICBC) stepped in to dramatically deepen the domestic convertible bond market this summer, the former issuing Rmb40 billion in CBs in June and the latter $25 billion in August.

In one fell swoop the banks boosted domestic CB market capitalisation to Rmb90 billion ($13.5 billion), from Rmb10 billion at the start of this year, and this expanded pool of assets has captured the imagination of the country’s FMCs.

“On hearing that BoC was going to issue CBs, we felt that the opportunity to launch CB fund products was approaching,” says Guibin Yang, the manager of Fullgoal’s forthcoming CB fund.

Convertible bonds, with their dual debt and equity features, are attractive to investors since their price rises in sync with the issuer company’s shares in a bull market but the losses are capped in a bear market, notes Yang.

Evidence of the correlation between CB prices and stock market performance can be seen in the 17% increase in the Tianxiang CB index in the second half of this year to date, alongside a 31% surge in Shanghai A-share Index over the same period.

Capital inflow into China’s CB market has also become super strong. The country's 60 FMCs report that the percentage of CB holdings by fixed-income funds in China hit a historical high of 8.53% in the third quarter, from 4.86% in the second quarter.

Gang Luo, fixed-income analyst at Hongyuan Securities, suggests China's recent equity market rally has really rolled out the red carpet for CB fund launches. “The strong performance of CBs is believed to be sustainable, since the stock market will remain bullish in the days to come,” he says.

Luo readily expects more FMCs to follow in the footsteps of Bosera and Fullgoal and launch CB funds.

There are 12 CB issues in the pipeline with total market capitalisation of about Rmb40 billion, statistics show. If Sinopec launches its Rmb23 billion CB (which has already received shareholders’ blessing) by the end of the year, China’s CB market will run over the Rmb100 billon milestone for the first time.

However, while the country’s market for convertible bonds is expanding, its size remains relatively limited. “Illiquidity is the biggest challenge for [CB] fund managers,” suggests Luo, noting effective liquidity management requires fund managers to sacrifice some profit margin.

“When the [CB] price goes up, it’s difficult to buy enough volume,” adds Yang. “The more orders you place, the higher you will bid up the price. The best opportunity to build a position is when the market goes down, and then to liquidate the position when the market goes upwards.”

The CB fund mandates of Bosera and Fullgoal are similar: The percentage of fixed income assets within each should be at least 80%, of which at least 80% should be allocated to CBs.

Yang notes that some convertible bonds issued by companies operating in cyclical industries have risen very quickly in price, driven by expectations of inflation and a weakening dollar.

On 20 consecutive trading days from mid-August, the closing price of Yunnan Tin's CB, for example, soared above the conversion price and eventually hit Rmb210 per unit on November 2, triggering redemption terms. The company will start to call back its CBs at Rmb104.51 per unit from December 3.

Luo suggests that fund managers already in the CB market or set to join will seek to allocate the majority of their assets into the two heavyweight bonds issued by BoC and ICBC.

“The dividend yields of the two banks are around 5%, higher than the 4.7% coupon rate of their subordinate debts,” Luo notes. “This means the share prices of the two banks are undervalued, and so are the CBs.”

Yang suggests that for the remaining part of the portfolio of at least 20%, he will build positions in the stocks of the CB issuers. “Usually the stocks with CBs outperform,” he says. “And shareholders of a company usually enjoy priority to subscribe for future CB launches.”

He also notes potential price arbitrage opportunities, citing the example of Yanjing Beer, whose CBs shot up by 40% on their November 3 debut, while the stock price rose just 2.54%.

Jun Guo, manager of Bosera’s CB fund, believes China’s CB market shows potential for long-term investment too, pointing out that the average CB conversion premium stands at 30-35%.