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Nikko picks specific onshore bonds

China's onshore defaults will surpass last year’s total, but Wong Yii Hui said her highly-concentrated portfolio avoids certain companies.

Threats to China’s markets have been accumulating – the escalating trade dispute, slowing GDP growth, a falling currency, over-leveraged corporate credit, pressure on the technology sector driven by Huawei’s troubles in the US – are among the risks.

Yet Nikko’s China Onshore Bond Fund, run by Wong, senior portfolio manager at Nikko Asset Management, is up 3.26% year-to-date in RMB terms, although it under-performed the peer category average (4.38%), according to FE data.

The highly-concentrated portfolio has only 21 holdings and the top ten account for about 60% of the fund.

Top three holdings are China State Construction Engineering, which is 6.05% of the portfolio, followed by Bank of China and Beijing Infrastructure. All three are yielding 4%-5%.

Wong’s uses an RQFII quota to invest in onshore bonds, going through both the CIBM and the Bond Connect. The fund aims for a consistent return and avoids too much “unnecessary binary risk”, Wong said.

High yield is a small percentage of the portfolio, comprising under 10% due to liquidity issues (the fund promises daily liquidity), Wong said. Non-investment grade bonds make up 10%-20% and are typically rated just below investment grade.

“The portfolio is skewed toward rates bonds [government banks and policy bank bonds, for example] and the total return comes from the rates portion.

“The credit part of the portfolio has a yield pickup because it has a short duration of three years and below, even with volatility, yield continues to contribute to the portfolio.”

She remains positive on rates bonds, which are expected to outperform because the central bank is expected to ease interest rates due to the trade dispute and weakening economy. Invesco had similar sentiments, FSA reported earlier.

However, because Wong’s fund is RMB-denominated – unhedged – investors are taking on a currency risk, she added. China’s currency hit an 11-year low versus the US dollar last week.

Default risk?

Onshore bond default rates have surged in the first half to about 100 compared to 179 for the full year 2018, according to data provider Wind.

“There will be more defaults,” Wong said. “State-owned enterprises can get credit easily but privately-owned and small and medium size companies are credit-constrained onshore.”

But she takes some comfort in the fact that defaults are still a tiny part of the overall credit market.

At the end of Q2 onshore defaults represented 1% of the credit sphere and bank non-performing loans were 1.8% on average of total corporate loans (at least according to official figures), she said.

“Defaults in China only started to occur in 2014. In terms of resolution, it is not yet clear to investors on- or offshore, how the default process actually works and how investors are being treated.”

Nikko doesn’t use onshore ratings agencies. It has its own proprietary credit ratings, which are developed by a Singapore-based credit team.

For additional input, the firm works with joint venture partner, Shenzhen-based Rongtong Fund Management, which Wong said has contact with the regulators and banks and transacts onshore.

She speaks to the risk team weekly and they discuss specific issues such as detracting factors in the portfolio and deviation from the planned tracking error. The team also runs stress test scenarios on issuers to discuss with the portfolio managers.

She believes the credit team can generally see when a company will be up- or downgraded and said the fund, which she took over in March 2019 after joining Nikko from UBS AM, has had no defaults.

Transparency is still a concern with certain issuers, she said. “We’ve seen some [companies] that have traded on the exchange have cash and then the next day they can’t make their payments.

“Some names we don’t touch if it is difficult to get information or no one covers it or you don’t know which bank is lending to them.

“But China is not different from other emerging markets, and more onshore companies are also issuing offshore bonds which are rated by international ratings agencies. You get more familiar with these companies, they issue frequently and you talk to management and you can see the direction they are heading.”

Nikko’s China Onshore Bond Fund vs the sector

Source: FE. Three-year performance in RMB. The fund does not have a specified benchmark. Note: Wong took over the fund in March 2019.

Part of the Mark Allen Group.