Chinese Bond Stress Shows Money Fund Liquidity Risk

Fitch-rated Chinese money-market funds (MMFs) - all rated ’AAAmmf(chn)’ - have withstood the recent volatility in the Chinese bond market, as these are generally more liquid and less sensitive to movements in short-term yields. However, some non-rated money funds were affected, particularly those with a more concentrated investor base or those that have attracted strong inflows of hot money.

Regulation announced in December 2015 has dampened the effect of the bond market volatility on Chinese MMFs to some extent, through tightening rules on weighted average maturity, credit quality of underlying assets and net asset value (NAV) deviation. This has significantly reduced the variance in yields for the sector.

The regulation, with an implementation period of up to a year for certain rules, also introduced liquidity fees and gates to prevent large-scale redemptions when MMFs are under stress. The fund manager is required to adjust the portfolio (sell assets, introduce liquidity fees or redemption gates) once the absolute value of the negative NAV deviation exceeds 0.25%, so that the shortfall comes back in line within five trading days. While these prudential regulations are a step in the right direction, they still trail regulatory standards for money funds in the US and Europe.

The Chinese central bank’s tightening on liquidity, combined with the US rate rise, triggered a selloff in Chinese government bonds and corporate credit in mid-December 2016. The 10-year government bond yield soared to 3.4% in mid-December from 2.6% at the beginning of November.

Some money-market exchange-traded funds (ETFs) experienced price volatility (although not necessarily NAV volatility) during this period. Data on MMF NAVs during this period are not publically available. However, the stress experienced by some money-market ETFs suggests that the NAVs of some MMFs may have also come under pressure.

If the natural liquidity of the affected funds were insufficient to meet redemption needs then fund managers would probably have sold assets for liquidity. They could also have implemented liquidity fees or set up liquidity gates to prevent further redemptions, although we are not aware of such actions being taken.

Chinese financial institutions account for most institutional investors in money funds in China, in contrast to the corporate investor base typically seen in European and US money funds. These financial institutions pose liquidity challenges to funds for several reasons. First, they are typically large, which may result in a concentration of investor funds. Second, they may be highly sensitive to market movements, resulting in volatile flows. Third, they are aware of the new regulations in China providing for potential liquidity fees or redemption gates and, as such, may be more likely to redeem early, in anticipation of these measures being deployed.

Total asset under management of Chinese MMFs fell to CNY4.3trn at end-2016 from CNY4.4trn at end-September 2016, according to the Asset Management Association of China. Some Chinese MMFs experienced severe outflows. None of the four Fitch-rated Chinese MMFs experienced large redemptions during the December bond market crash, reflecting their conservative investment guidelines, and prudent liquidity and risk-management practices.