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By Michael Rawson, CFA | 10-21-2011 10:40 AM

Pass on Dim Sum Bond ETFs

Huge demand for the tiny market of local-currency-denominated Chinese debt means investors aren't being compensated for the risks they are taking, says Morningstar's Patty Oey.

Mike Rawson: Dim sum, it's not just for breakfast anymore.

Hi, there. I'm Mike Rawson, ETF analyst with Morningstar. Joining me today is Patty Oey, also an ETF analyst with Morningstar.

Patty, thanks for joining me.

Patricia Oey: Thanks for having me.

Rawson: Patty, in the last month, three ETFs have launched which track dim sum bonds. First of all, what are dim sum bonds, and why all the interest all of a sudden?

Oey: Dim sum bonds are Chinese currency-denominated bonds, and they are available to foreign investors. So, as many people know, China employs very strict capital control. So, generally it's very difficult for foreign investors to access local bonds and the currency as well. So, there has been a lot of interest in dim sum bonds, because investors are trying to access the anticipated appreciation of the Chinese currency.

Rawson: So, when you dig into these ETFs, what are some of the key points that investors should be aware of?

Oey: Well, actually investors should realize that this asset class is still very, very small and relatively very young. The first dim sum bond launched about a couple of years ago, and right now the whole market of total bonds outstanding is only about US$30 billion, which is very small. Other emerging market local currency debt markets are actually much larger, and the whole emerging market local currency market is about $6 trillion. So Chinese dim sum bonds are currently less than 1%. And just to put that in context, if you look at the equity market, the MSCI Emerging Markets Index, China accounts for about 16% of that index. So, their local bond market is still very, very, very small. I also want to highlight, because the asset class is still very small, but demand has been very, very strong, credit spreads are actually very tight, and they're tighter relative to comparable markets.

And investors should also know the credit risk. Most of the issuers of dim sum bonds have been Chinese banks, and there is definitely a lot of concern about their balance sheets, given their surge in loan growth during 2009 as part of the government stimulus.

Rawson: OK. So, what you're saying is, despite the fact that some of these bonds have some credit risk, the investor demand has been so strong that investors may not be getting compensated for the risks they're taking?

Oey: Yes.

Rawson: What other risks are there? You mentioned that China has just recently begun to open up its bond markets and its currently market. Are there any other risks in terms of the regulatory risks that investors face?

Oey: I definitely think regulatory risk is an issue. ... Dim sum bonds were created as part of the Chinese government's efforts to internationalize their currency, but in the near term, they ... will still try to control their currency. So, I think it's going to be a very difficult balancing act.

So, any kind of change in the regulatory environment can definitely affect the supply and demand, and then can affect the valuation of these bonds. Also right now, we are in a current environment where global market volatility is at a relatively high. We could see the Chinese government become more cautious, and that could be a negative.

Rawson: So we've heard about the fact that the Chinese economy is very large, maybe the second largest economy in the world. Most investors probably have a very small, if any, allocation to Chinese growth in the Chinese economy. This is one way which they could get some access to the Chinese economy. So would you recommend to investors to go out and buy these funds right now?

Oey: Well, I do think that the ... market size is still very small. So, I think it's not a good idea to buy this dim sum bonds right now. I know investors are very interested in accessing Chinese growth. There is also an handful of ETFs and ETNs that provide currency exposure by holding swaps and currency forwards, and actually those products haven't tracked the appreciation of the Chinese currency that well, either. So I wouldn't necessarily recommend those, either.

The best option right now is perhaps to buy a diversified Asian local currency bond ETF. WisdomTree has one. The ticker is ALD. They recently started including Chinese dim sum bonds in their portfolio. Right now, it accounts for 6%, but it's broadly diversified. It also invests in local currency debt of Malaysia, Indonesia, and other countries like that. And we prefer a little bit more of a diversified product.

Rawson: Patty, thanks for those insights.

I'm Mike Rawson with Morningstar. For more information on ETFs, check out etf.morningstar.com.

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