* Country becomes single largest component of JP Morgan Asia Credit Index
* Continued China issuance likely to increase the bias
* Investors question logic that defines inclusion
By Christopher Langner
SINGAPORE, Dec 19 (IFR) - Chinese companies that have found liquidity conditions and bank lending caps too onerous at home have turned to foreign bond markets in force, becoming the largest source of hard currency bonds in Asia last year.
Chinese firms offered US$68.5bn in G3 currency bonds, about 46% of the record US$148bn in total issuance this year, according to Thomson Reuters.
The surge in China bonds poses a challenge for some investment funds, however, as Asian bond indices have become heavily skewed to China exposure.
According to a recent Moody’s report, China bonds as of the end of November represented 25.8% or $115bn of the US$446bn in bonds in the JP Morgan Asian Credit Index, making it the dominant issuer.
Since March 2012, the number of China securities in the index swelled to 200 from 80, Moody’s said. About $16.1 billion of Chinese corporate issuance this year through November was in high-yield credits, largely from residential property companies, the rating agency added.
As recently as last year, South Korea’s bonds were still the largest geographical component of the JACI, which tracks the Asia fixed-rate dollar bond market and is one of the most followed benchmarks in the region.
The overexposure of China within the index is likely to increase next year, as bankers anticipate the country will continue to be the largest source of bond issuance in the region amid tight liquidity onshore.
This has some investors claiming the JACI is an imperfect gauge of Asian markets.
Perhaps more worrying for passive funds that follow a benchmark like the JACI is the fact a growing number of Chinese bonds included in the index hardly ever trade. In the past year several Chinese dollar bonds were bought heavily by Chinese banks, which keep them on their balance sheets.
Chinese banks, for instance, bought about 35% of China Merchants Land’s bonds in early December. The bonds have a standby letter of credit from ICBC (Asia). About 57% of China State Shipbuilding Corp’s December bonds, carrying a standby letter of credit from China Construction Bank, went to such buyers.
Most Chinese dollar bonds met the requirements of the index in 2013, despite the limited number of bonds available in the secondary market. Passive funds pegged to Asia indices like the JACI have to scramble for the few bonds available, which in turn, may artificially inflate their prices.
Perhaps the biggest issue is that as China transfers more of its debt abroad, JACI-benchmarked funds will be forced to buy more of its debt, exposing them more heavily to any hiccups in the country.
The problem exemplified by the JACI is hardly exclusive to the JP Morgan index. Most key fixed income indices in the world are market cap weighted, which means that as a company, or country, issues more debt, that company becomes more important to the performance of the index.
“It kind of does not make sense - if a company is issuing too much debt, maybe I should actually be avoiding it, but if it is in the index I have to buy,” said an asset manager.
In the JACI, the problem is overexposure to a single country. The Barclays Aggregate Bond Indices, however, are geared more to individual issuers.
The discussion arrives at a time when many investors are questioning Nobel laureate Eugene Fama’s concept that over time following a benchmark results in better gains than active management.
A growing number of institutional accounts are seeking actively-managed total return funds over index funds because they can no longer afford to have negative returns even if they are beating a benchmark, Michael J Kelly, managing director of global asset allocation and structured equities at Pinebridge Investments said in a recent interview.
If true, that would mark a reversal of recent trends. Indeed, in its latest report on mutual fund flows in October, Morningstar noted that flows out of active US equity funds are slowing, although a full rotation out of index funds and into active strategies has not materialized. For the year through October, active funds lost $15.3 billion compared with outflows of $131.5 billion in 2012.
The trend seems to be clearer in equities, but the recent unhappiness with the JACI suggests fixed income investors also are showing index fatigue.
The fact the JACI returned a negative 1.22% this year does not help. The US Federal Reserve’s decision to begin tapering its stimulus programme means prices of outstanding bonds are likely to drop, leading strategists to predict an even worse performance for the index next year.
Retail investors in Asia are renowned for focusing on total return regardless of how it compares to benchmarks. Asset managers in Asia confirm institutional accounts have started to take the same approach.
China’s growing dominance of the index is likely to nudge that trend along. (Reporting By Christopher Langner, editing by Abby Schultz)