The Chinese yuan, also known as the renminbi, is already convertible under the current account - the broadest measure of trade in goods and services. However, the capital account, which covers portfolio investment and borrowing, is still closely managed by Beijing because of worries about abrupt capital flows.
Asian bonds a gamble for iShares
New offshore yuan-denominated bond ETF will face problem of tracking illiquid Asian bonds
Hongkongers like bonds, yuan and exchange-traded funds. So iShares had the brilliant idea of combining all three, creating Hong Kong's first offshore yuan-denominated bond ETF.
The fund iShares RMB Bond Index ETF will start trading in Hong Kong tomorrow.
Jane Leung, head of iShares Asia Pacific, says the fund targets those holding yuan, who are looking for extra yield on their bank deposits.
The fund aims to replicate the performance of the Citi RMB Bond Capped Index, which was yielding 3.2 per cent as of April 30, says Leung. The fund involves an expense ratio (which measures all costs and expenses of a fund) of 0.39 per cent - low by industry standards.
It's a great concept, but there is a reason why no one has done this before. It's tough for ETFs to track bonds generally and illiquid Asian bonds in particular.
Of the 111 ETFs that trade in Hong Kong, only two are invested in bonds.
It is relatively easy for ETF providers to track stock indices as the shares underlying these benchmarks are easy to buy and sell, with a minimal spread between the bid and offer price. This means the index providers can continuously fine-tune their portfolio to better track their chosen benchmark.
This is less true for bonds, which typically do not trade on an exchange or, even if they do, not in heavy volumes. This means that the underlying bonds are more expensive to buy and sell, translating into a relatively wide bid-offer spread for bond ETFs. This essentially means an investor has to pay more to exit a fund.
Bloomberg data, for example, shows that the bid-offer spread for Hong Kong's Tracker fund, a big equity ETF, is 0.05. The spread for the ABF Pan Asia Bond Index Fund is 13 times as wide, at 0.65.
Marco Montanari, Deutsche Asset & Wealth Management's head of passive asset management, says Asian bonds are less liquid than European or US ones, making it challenging to structure ETFs linked to Asian bonds.
Moreover, several Asian countries are rated below investment grade (BBB-minus or below), and many funds are required by mandate only to invest in investment-grade securities.
Bond prices also change depending on how close they are to maturing. This all means managers of bond ETFs have to constantly rebalance their fund with longer-date bonds, which creates cost and tracking error.
Long story short, managers of equity ETFs do not have this problem as shares have no maturity date. This is another factor that makes equities easier to manage than bonds in an ETF.
Nevertheless, illiquidity, wide bid-offer spreads and duration risk are a fact of bond investing, and this has not deterred investors from buying unlisted mutual funds stuffed with regional debt - high-yield bonds are Hong Kong's most popular fund category. And ETFs arguably offer a cheaper and more transparent way to buy the same asset.
Montanari says fixed-income ETFs now represent around 20 per cent of the assets managed by ETFs while in Asia it is less than 5 per cent. In other words, the instrument has room to grow.
"The trend picked up in Europe and in the US in the last few years thanks to more education and also thanks to more challenging equity markets which pushed several investors to fixed income products," Montanari says. "If around 50 per cent of the mutual funds' assets are in fixed-income funds, there is no reason why the same percentage should not apply to fixed-income ETFs in the long run. It's just a question of time."