How a Misunderstanding About Chinese Characters Points to an Offshore Corporate Bond Fund as a Potential Cautious Haven in the Global Financial Crisis, Contributed by Warren Cabral, Appleby
Contrary to popular belief, the Chinese word for “crisis” does not signify “danger” and “opportunity.” A whole industry of pundits and therapists has grown up around this one inaccurate statement, says Professor Victor Mair, a Professor of Chinese language and literature at the University of Pennsylvania. He says the Chinese word for crisis “Weiji” is comprised of two components, neither of which independently signifies either danger or opportunity.1 The parts cannot stand alone, even though one of the parts “ji” might also appear in words like “jihui” meaning “opportunity.”
Thus a Weiji is indeed a genuine crisis, a dangerous moment, a time when things start to go awry. A Weiji indicates a perilous situation when one should be especially wary. According to Professor Mair, it is not a junction where one goes looking for advantages and benefits. Professor Mair says, “in a crisis, one wants above all to save one’s neck. Any would-be guru who advocates opportunism in the face of crisis will only compound the danger of the crisis.”
Today’s financial crisis also has a Greek connection, naturally. The word “crisis” entered the English language around 1425 with the meaning of “turning point in a disease.” It was borrowed from “crisis” in Latin which in turn comes from the Greek “kirsis” meaning a “separating, distinguishing, discrimination, decision or judgement.” Thus, the old Greek usage would be somewhat better positioned to serve as a justification for the “danger plus opportunity” meme than does Chinese Weiji, which, from the very beginning, is always something worrisome and unwanted, calling for caution.
Whichever meaning one attaches to crisis it is clear that the world is at a turning point calling for hard decisions. Thus, in the Chinese fashion, caution is the key. The question then arises as to what reflects cautious investing in the current global financial crisis? Certainly the Chinese are showing caution in avoiding entanglement in the European debt farrago – but what is the investor to do in such a climate? How to take caution and yet still beat inflation? What ji could be added to make an opportunity?
Not surprisingly, the answer seems to be a fund investing widely but cautiously with an added edge outside of investment risk. This points to offshore funds. The Investment Management Association (IMA) defines a cautious managed fund as one investing in a range of assets with maximum equity exposure restricted to 60 percent of the fund and with at least 30 percent invested in fixed interest or cash. There is no specific requirement to hold a minimum percentage of non-UK equity within the equity limits. Assets must be at least 50 percent in sterling/euro and equities are deemed to include convertible bonds. That is to say, a mixed portfolio which includes bonds. What is good about corporate bonds is that they rank higher in the pecking order than shareholders. In other words, investors still may get paid even if the stock price plunges. Note that lower rated corporate bonds yield more than top notch issues of shares, reflecting the higher risk investors take when they buy them. After corporate bonds are issued they can be traded just like shares.
Accordingly, the cautious investor would want a multi-asset fund that invests in a diverse portfolio of equities, bonds, commercial property and other investment assets. By investing in a wide range of different investment assets, the fund manager aims to limit the risks associated with any one type of asset. It follows one of the oldest principles of investment, summed up by the old adage about not putting all of one’s eggs in a single basket. Apart from investing in other mixed funds, such a multi-asset fund will also invest in individual stocks and bonds. Through such investments the cautious saver will gain investment exposure across a range of global geographical areas and asset classes but with core holdings in UK bonds and equities.
As can be seen, then, bonds are an essential part of the mix. Investors nervous about the volatility of the global equity markets and wary of possible sovereign debt defaults have sought more attractive risk adjusted returns by switching into corporate bonds. By one estimate, in the year to 31 August 2011, the corporate bond sector experienced an estimated net inflow of almost $10 billion.
The post Lehman Brothers credit crisis of 2008 forced many large companies to deleverage and this resulted in some strong balance sheets. Consequently, investment grade corporate bonds now look like a better proposition than significant parts of the sovereign debt market. Even so, corporate bond risk premiums have increased – risk premiums on corporate bonds have risen to their highest level this year amid continued jitters about a Greek default and slowing economic growth. The sell-off in the credit markets has left investors wary of a re-run of last year’s market plunge with Euro-zone sovereign default fears resulting in soaring spreads and at one point a virtual shutdown of the corporate bond markets. Despite the wider spreads with gilts the cost of borrowing for U.S. companies with investment grade credit rating has, nevertheless, fallen recently reflecting the sharp decline in Treasury yields, investors are becoming particularly wary of riskier companies; Bank of America, Merrill Lynch analysts estimated that about $1 billion had been taken out of high yield mutual funds in the last week.
All of which indicates a flight to cautious investing, namely into funds rather than individual bonds issued by large-cap companies. And preferably exchange traded funds. There are only a dozen exchange traded funds in the corporate bond sector that have been around for the last five years, and all but one of them is up close to 50 percent or more over that period. Thus there appears to be an “edge” attached to funds of corporate bonds.
Today there are over 9,000 companies in the world’s main global indices. Only around 1,600 are defined as large-cap, making the base majority of listed shares smaller companies. Some fund managers say the inherent characteristics of small companies, entrepreneurialism, dynamism and alignment of management interests, in some instances have led to strong rates of growth – a rare commodity these days. Accordingly, in their view, smaller company investing can have a positive impact on investors’ portfolios from a risk and return perspective. History also has shown that smaller companies can provide substantial diversification benefits to a portfolio of bonds, which many investors are heavily exposed to today.
A paper published by Invesco Perpetual draws on research which has analysed the diversification benefits and outperformance of global smaller companies against other major asset classes.2 Invesco says the report shows how the positive role played by global smaller companies in a portfolio tends to be significantly underestimated and they believe that the perceived risks of investing in the asset classes are often overstated. The perception is that investing in smaller companies is intolerably risky but they believe, as is often the case, the perception is far from reality.
While the importance of portfolio diversification across asset classes is well recognised, UK investors still have little exposure to global smaller companies generally due to such concerns about risk. Looking at the UK IMA Sector aggregates, for example, investors currently have very limited exposure to smaller companies within the Global sector. This is all the more significant given that small caps represent 15 percent of global stocks markets, rising to 30 percent for small and mid caps combined. So, how does one compensate for the perceived risk? High rates indicate high risk. Is the correct approach to add in a factor not correlated to investment risk, but which nevertheless contributes to the overall return?
One also may ask whether offshore bonds give an “edge” to what would otherwise be an investment with lower risk but lower rate return? Prudential International have established an offshore fund which has the advantage of being tax efficient from a UK perspective in that it enables gross roll-up, meaning the main tax benefit of investing in an offshore bond is gross roll up. Gross roll-up means that any underlying investment gains are not subject to tax at source apart from an element of withholding tax. Corporate investors, however, do not enjoy the same 5 percent deferred tax allowance as individual tax payers. How then can the corporate investor obtain a similar “edge”?
Specialists in offshore funds say the benefits of an investment fund established offshore in jurisdictions like the Cayman Islands or the British Virgin Islands (BVI) are that there are tax benefits, namely no direct taxation in the Cayman Islands nor in the BVI. There is also a flexibility of funds structure; there is speed of establishment of structures. There are no restrictions on the appointment of a funds investment manager, advisor, client broker or custodian. There are no resident requirements for directors and no requirement to appoint local functionaries. There is wide availability of world class professional services. Both BVI and Cayman are politically and economically stable jurisdictions with business oriented Governments. A trustworthy and reliable legal system based on English common law, supplemented by local legislation and established anti-money laundering regulation completes the picture. All of these elements reduce the “frictional cost” of operating the fund, so contributing to profitability.
Similarly, Guernsey offers equivalent advantages and offers corporate bonds funds, which seek to obtain a higher total return than gilts.
For corporate or high net worth investors, an exchange traded offshore fund might be a way to enhance low-risk returns. But for small private investors, investing through corporate bonds, namely loans of big companies that have traded on an exchange, is still perceived as potentially dangerous. The corporate bond exchange has yet to spark serious investment for everyday private investors but with some of the big companies like Lloyds Bank plc and Tesco plc dipping more than a toe in this market it is ready for a makeover. To get some diversification, a corporate bonds fund can be set up as an alternative as they use a basket of individual bonds to spread risk and such bond funds can be listed on a stock exchange to provide liquidity. Corporate bonds often are listed on major exchanges (e.g., the London Stock Exchange (LSE)) and usually are taxable. Sometimes the coupon can be zero with a high redemption value. However, despite being listed on exchanges, the vast majority of trading volume in corporate bonds in most developed markets takes place in the decentralised, dealer based, over-the-counter market.
The LSE launched its new electronic audit book for retail bonds earlier this year. It was introduced in response to strong private sector demand for greater access to fixed income, and it offers continuous two-way pricing for trading in UK gilts and retail sized corporate bonds on the exchange. For the first time ordinary individuals in the UK have a dedicated platform that will allow them to invest modest amounts of money in individual company bonds. At a time when equity markets have been volatile, and interest rates have remained low, this represents a new way for private investors to save while supporting the capital raising needs of British companies.
Offshore bond funds also are traded on the LSE. Typically, retail investors have bought corporate bonds through funds. Offshore funds are an opportunity to aggregate a variety of corporate bonds under one umbrella and the investment fund vehicle itself will enjoy additional benefits by reason of being offshore which feed through to returns available to investors. Again, it can be seen that for both corporate and private investors, “offshore” provides a desirable fillip to the investment return, whilst preserving a cautious approach in the global crisis.
It is said that the UK Government is pinning its hopes for so called credit easing on the British bourse and its market for allowing retail investors to invest in corporate bonds. Credit easing will at first see the Government inject billions of pounds into the corporate bond market by buying bonds in larger companies, but the Chancellor of the Exchequer then hopes to create a small and medium sized enterprise (SME) bonds market encouraging banks to package up parcels of debt issued by smaller companies. This would fit neatly with the Invesco Perpetual model.
In a world in crisis, forced to make decisions at a turning point of global financial health, the cautious investor may well look for opportunity amidst the danger. One potential refuge may well be the incremental part, the ji, offered via offshore corporate bond funds. Where have the Chinese put their money? Certainly, entities established in the British Virgin Islands and the Cayman Islands are collectively the largest inward investors into China. Jihui!
Warren Cabral is managing partner of the London office and a partner in the Corporate & Commercial department at offshore law firm Appleby. Warren has over twenty years’ experience of complex cross-border commercial transactions. Able to advise on Bermuda and British Virgin Islands law, Warren is particularly expert in public offerings, corporate finance, and mergers and acquisitions. Telephone: +44 (0) 20 7469 0521; E-mail: email@example.com.
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