Summary The first ETF offering USD Investment grade Bond exposure with an attractive yield, but is the duration short enough to weather a Fed tightening? As a new ETF in a foreign market, will it survive in a market with a dearth of issues? We answer these questions and determine if this new ETF can be a “cash cow” for investors seeking Asia USD fixed income exposure. The BMO Asia USD Investment Grade Bond ETF {3141.HK}, is a recently issued Investment Grade ETF and the first to offer Asia USD exposure on the Stock Exchange in Hong Kong. According to fund sponsor, Bank of Montreal BMO Asia: The investment objective of the BMO Asia USD Investment Grade Bond ETF is to provide investment results that, before fees and expenses, closely correspond to the performance of the Barclays Asia USD Investment Grade Bond Index. We examined this young ETF, its underlying index, its holdings, credit structure, and its overall risks in Asia with the possibility of rising rates in 2015 and provide our recommendation. The ETF, uses a numbered ticker symbol of 3141.HK and has no letter symbol at this time, is denominated in U.S. dollars and generates U.S. dollar income. One of the extremely positive factors of the ETF is that the HK dollar is fixed against the USD and has been since 1983. Every HK dollar is fully backed by U.S. dollars assuring convertibility in an extremely narrow trading range. (Currently approximately 7.75HKD=$1.00 USD, reciprocal= .1275). Currently the ETF has 67 issues while the underlying index, The Barclays Asia USD Investment Grade Bond Index, with a ticker symbol of {BAIGTRUU} has 502 issues. The index, according to Barclay’s has specific requirements for inclusion. They are as follows: The Barclays Asia USD Investment Grade Bond Index is a market capitalization weighted index which measures the performance of fixed rate USD denominated government-related and corporate investment grade bonds of the Asia ex-Japan region. The bonds must have a minimum outstanding amount of USD350 million and be rated at or above Baa3/BBB-/BBB- using the middle rating of Moody’s, S&P and Fitch to be included in the Index. The Index may also include non-rated bonds issued by investment grade issuers. The Index is subject to an issuer cap of 4%. The fund uses a sampling approach within its passive management style. We broke down the ETF to determine its structure and risk factors. We began with the geographic allocation of the ETF components. 3141.HK Geographic Weights Country Weight China 34.98% South Korea 17.06% Hong Kong 11.67% India 9.88% Indonesia 9.11% Philippines 4.94% Singapore 4.23% Thailand 3.63% Malaysia 3.26% With a total of 46.65% or almost half of the ETF composed of China and Hong Kong the ETF is obviously heavily dependent on the greater China region. Though we do not have currency risks in this ETF there is a risk of a slowdown in China going forward. Though we do not have complete faith in the China GDP figures, we do feel that the investment grade companies in the region for the most part are transparent. We feel that the quality of the issues in Hong Kong is above board. Though there is some trepidation in Hong Kong of interest rate increases, (which is tied to U.S. Fed policy), we do not consider this an issue for any of these issues. Though the Chinese companies, on the whole, may have unknown tax and regulatory issues going forward, we feel at this time proper Internal Controls are in place and auditors have been filtered, (after issues in China in the recent past). In order to review overall interest rate risks we examined the maturity structure of the ETF. It is quite simplistic. Maturity Structure Maturity Weight 0-3 years 19.27% 3-5 years 29.57% 5-7 years 19.24% 7-10 years 23.26% 10+ years 8.24% With 68.08% of the issues from 0-7 years and 91.34% from 0-10 years we have comfortable interest rate exposure on these short to medium term fixed income securities. They are essentially notes and only 8.24% of the ETF would be considered bonds in a capital markets definition. We will review the duration of the ETF and various returns later in our analysis. In terms of the industry and sector breakdown, BMO gives a basic breakdown of 55.38% Government related and 43.31% Corporate. Unfortunately, this is not adequate for our analysis. We need to determine what is cyclical, energy related, interest rate sensitive, etc. As such, we did a complete analysis of the individual holdings and have broken them down as follows: 3141.HK Sector Analysis Sector Weight Banks 28.89% Energy 24.33% Government and Sovereign Related 8.84% Home Building 7.85% Utilities 6.92% IT Services and Transaction Processors 5.99% Business Services, Consumer Services 5.70% Finance and Insurance 4.11% Telecommunications 1.79% Construction and Engineering Services 1.67% Commodities, Merchandising and Processing 0.92% Transportation Services 0.88% Industrial Products 0.87% In the course of our analysis we did consolidate certain categories such as Finance and Insurance and Business Services with Consumer Services. In general, the sector breakdown reflects an accurate assessment of the categories of the ETF. With banks and energy making up 53.22% of the ETF, we do see interest rate risk here along with energy exposure. It should be noted that many of the banks and energy companies though not state owned, do have tangible links to many of the governments, especially in Mainland China. We feel that any slowdown in the general economy barring a recession in Mainland China will not result in downgrades in the underlying issues. Any interest rate increases in the U.S. will of course be reflected in higher rates in U.S. dollar deposits and subsequently, HK based debt. We do feel comfortable with the short maturities here and general duration, which provides some immunization with higher rates, should that occur. In terms of the energy sector, while lower energy prices in general may result in a slight revenue decrease, we do not feel that will result in downgrades in the next few years, at least. In addition, in general both the U.S. and the greater China region will benefit from lower oil prices. The demand is expected to remain high in Asia for the foreseeable future and energy prices as most economists enjoy stating, “are sticky” in nature. In terms of the other sectors we feel comfortable with utilities, home builders (in spite of excess inventory in Mainland China), IT Services and Transaction Processors, i.e. Baidu. We were a little surprised to see the commodities category composed of the large trading firm, Noble Group, which has major trading operations in Asia and is expanding in the region. In terms of credit quality, BMO uses the middle rating of Moody’s, S&P and Fitch. According to the prospectus when a rating from only two agencies is available the lower is used. In addition, when a rating from one agency is available, that rating is used to determine index eligibility. In our analysis we require the actual breakdown of both Moody’s and S&P of the ETF that we review to determine the credit risks. As such, we analyzed the holdings. For information purposes here are Moody’s and S&P ratings of 3141.HK 3141.HK Credit Analysis Moody’s Weight S&P Weight Aa1 2.57% AA 0.88% AA3 24.51% AA- 13.45% A1 16.28% A+ 22.27% A2 1.66% A 7.70% A3 19.23% A- 13.10% Upper Investment Grade 64.24% Upper Investment Grade 57.40% Baa1 9.68% BBB+ 17.04% Baa2 7.81% BBB 4.94% Baa3 17.02% BBB- 6.88% Lower Investment Grade 34.51% Lower Investment Grade 28.86% – – BB+ 7.38% – – BB 1.72% – – Non Investment Grade 9.10% – – Non Rated 3.40% – – Non Investment Grade + Non Rated 12.50% In our analysis we do like the overall upper and lower credit quality weights in Moody’s credit ratings, with over 2/3 of the ETF in high credit quality issues. We do find it interesting that S&P takes a more conservative stance on some of the issues in the region with non-investment grade ratings on some of the issues and non-rated on a few. Though we do find this a negative, the index and fund permit non-investment grade issues by one of the rating’s agencies as per the prospectus. The only issue here is the lack of proper disclosure of the over 10% weight within the Non-Investment Grade and Non-Rated category at S&P. In this case our analysis indicates that an investor should simply proceed with caution and understand the overall credit structure of the ETF. As we mentioned, our default or downgrade concerns are minimal. In order to fully understand the ETF, as usual, we analyzed the top 15 issues and analyzed their risks. For information purposes here are the top 15 issues, their equity, symbol if any, coupon, maturity, ratings and weight in the ETF. 3141.HK Top 15 Holdings Name/Symbol Coupon Maturity Moody’s/S&P Ratings Weight Alibaba Group Holding Ltd. BABA 3.60% 11/28/24 A1/A+ 2.66% Reliance Holding USA, Inc. {RLNIY} 4.50% 10/19/20 Baa2/BBB+ 2.16% PTTEP Canada (International Finance) Exploration and Production Company OTCPK:PEXNY 6.35% 06/12/42 Baa1/BBB+ 1.93% Perusahaan Penerbit SBSN Indonesia{none} 6.125% 03/15/19 Baa3/BB+ 1.82% China Overseas Finance (Cayman VI)Land and Investment Ltd. OTCPK:CAOVY 5.95% 05/08/24 Baa1/BBB+ 1.80% Republic of Philippines {none} 4.00% 01/15/21 Baa3/BBB 1.79% Bharti Airtel International, Netherlands BV OTC:BHRQY 5.35% 05/20/24 Baa3/BBB- 1.79% Mega Advance Investment Ltd, Beijing Enterprises Holdings OTC:BJINF 5.00% 05/12/21 A3/BBB+ 1.78% Hutchinson Whampoa International Ltd. OTCPK:HUWHY 4.625% 01/13/22 A3/A- 1.78% Swire Pacific MTN Financing Ltd. OTCPK:SWRAY 4.50% 10/09/23 A3/A- 1.77% Sun Hung Kai Properties, Capital Market Ltd OTCPK:SUHJY 4.50% 02/14/22 A1/A+ 1.76% CNOOC Finance Ltd. CEO 4.25% 01/26/21 Aa3/AA- 1.76% Bank of Baroda, London{none} 4.88% 07/23/19 Baa3/NR 1.75% CNPC, HK, Overseas capital Ltd. {none} 4.50% 04/28/21 A1/A+ 1.75% Hana Bank {none} 4.25% 06/14/17 A1/A 1.75% The top 15 holdings represent 28.05%, while the bottom 53 holdings plus cash equal 71.97% of the ETF. While this top 15 concentration is a little lower than our previous ETFs we have analyzed, it is quite acceptable. Surprisingly, it is only 6% higher than an equal weighted ETF, (15/68=22.05%). It simply means that the top 15 do not represent high concentrations and the 68 issues represent a diverse group of companies and their fixed income securities. It also gives investors an opportunity to invest in the debt of some well-known Asia firms such as Alibaba, and Baidu, BIDU , along with government and sovereign debt along with the publicly trading debt of State Owned Enterprises (SOE) without concentration risks. The portfolio has many regional and global names as well, such as Sinopec Shanghai Petrochemical Company Limited, SHI , DBS Group Holdings Ltd, OTCPK:DBSDY , and Hyundai Motor Co., Ltd., OTC:HYMPY , (Hyundai Capital America). Overall, we like the exposure to these well-known firms and feel the ETF is poised for steady returns into 2015 and beyond. In terms of performance the young fund obviously has a short performance history. We compared its performance to the underlying index, BAIGTRUU. 3141.HK Performance and Recommendation Category 3141.HK {ETF} BAIGTRUU {Index} Expenses .35% – Weighted Average Coupon 4.39% 4.24% Weighted Average Term 6.67 years 6.97 years Weighted Average YTM/Weighted Average Current Yield 3.01%/4.01% 3.00%/4.00%{estimate} Yield to Worst 3.30% {estimate} 3.29% Weighted Average Duration 5.22 years 5.36 years YTD Return – 8.04% As a comparison to other ETFs in the marketplace there are basically none. In the international corporate bond space there is the SPDR Barclays Capital International Corporate Bond ETF (NYSEARCA: IBND ), and the PowerShares International Corporate Bond Portfolio ETF (NYSEARCA: PICB ). Both of these ETFs have assets of over $250M and both of them are based upon issuers in foreign currencies. Being unhedged the ETFs do not protect against a strengthening dollar. As such, both of their returns are negative for 2014. A closer approximation to this ETF in terms of a US dollar foreign fixed income ETF, would be the iShares JPMorgan USD Emerging Markets ETF (NYSEARCA: EMB ), with over $4Bln in assets. It is in US dollars and invests in emerging markets and is up over 6.00% YTD. Unfortunately, EMB focus is on sovereign debt denominated in US dollars and not corporate debt. As such, we can state clearly that at this time, the BMO Asia USD Investment Grade Bond ETF is clearly without a comparison. With an inception date of November 07, 2014 the fund presently has assets under 100M and is growing. According to BMO, institutions have committed capital to the fund and more are expected to over time. With an expense ratio of .35% there are no issues regarding the expenses of this ETF and it is reasonable for a fixed income ETF. The duration of the ETF is quite attractive and is well within bounds for a medium term fixed income ETF. With distributions paid quarterly, the performance should match the current yield for the past two months combined on an annualized basis and the index return as well when distributed. With an attractive cash flow of over 4.00% on an annualized basis we recommend this young ETF as an attractive high quality “cash cow” for the greater China and Asia region within the fixed income space for 2015 and beyond. Additional disclosure: information obtained from BMO,HK website and directly from BMO Hk associates, indices.barcap.com, moodys.com, standardandpoors.com and our own analysis