China's shadow-banking bomb is ticking...

A 3 billion renminbi ($492 million) trust loan with the potential to default by the end of January could mark the first case of trust-product default in China — a development that we believe could have far-reaching implications. The product in question was issued by China Credit Trust (CCT) in 2011 with the promise of a 9.5–11.0% yield and a maturity of 3 years. ICBC, the largest bank in China, sold the product to 700 of its wealthy private banking clients.

Historically, the Chinese government has stepped in to prevent or mitigate large defaults or reorganizations, creating the perception of a moral hazard. This time, it appears the Chinese government will again step up to rescue the investors, but how far it will go remains a question. The CCT product was issued to finance an unlisted coal mining company, which is currently undergoing bankruptcy procedures; however, the asset value that has been recovered so far is much less than the company’s outstanding debt. One-third of China’s outstanding 4.6 trillion renminbi trust loans ($760 billion) are due to mature in 2014. In the second quarter of 2014, 6 billion renminbi in trust loans that financed the notoriously deadly mining industry are coming due.

While trust products have attracted China’s high net worth individuals and institutions with double-digit yields and 2-3 year maturities, wealth management products (WMPs) have been by far the most popular investment vehicle for ordinary Chinese savers looking for higher returns. WMPs share certain characteristics with structured investment vehicles (SIVs) and collateralized debt obligations (CDOs), both of which were used by U.S. banks before 2008 to keep loans off–balance sheet. A considerable portion of WMPs were also invested in the affected trust business. WMPs have typically yielded 4–6% (1–2 percentage points higher than bank deposits, on average) with 3–6 months of maturities, and generally are sold by banks to retail investors as low-risk investments. Rating agency Fitch estimated that around 13 trillion renminbi ($2.2 trillion) of WMPs were outstanding by mid-2013. Since then, growth has slowed after the government imposed new regulations on banks.

Given some of the risks that we see within the Chinese marketplace, we currently hold no direct exposure to China within the global real estate investment trust (REIT) portfolios that we manage.

Unless otherwise noted, developments cited throughout this commentary are supported by data published by Bloomberg.

The views expressed represent the Manager's assessment of the market environment as of January 2014, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.

REIT investments are subject to many of the risks associated with direct real estate ownership, including changes in economic conditions, credit risk, and interest rate fluctuations.

Structured investment vehicles are pools of investment assets that attempt to profit from credit spreads between short-term debt and long-term structured finance products such as asset-backed securities (ABS). A structured financial product that pools together cash flow-generating assets and repackages this asset pool into discrete tranches that can be sold to investors.

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Notes from the desk