China's wealthy are flocking to investment products that buy bank-issued securities and soup up returns using leverage. That is, they use borrowed funds to buy additional securities. If the securities end up with a higher rate of return than the borrowed funds, then the investment product can make high returns.

Elm BV, a special-purpose vehicle used by UBS Group AG, has sold 3.7 billion yuan ($555 million) of structured notes in 18 offerings since 2015 with yields as high as 15 percent, data compiled by Bloomberg show. Goldman Sachs Group Inc, Societe Generale SA and Guotai Junan Securities Hong Kong Ltd have also designed such products, which often use leverage to invest in US currency capital securities. Chinese banks sold at least $27.7 billion of Basel III notes offshore since the first issuance in 2014.

"I expect demand for such structured notes to continue growing as the Chinese are still looking for better yields given the current low returns on Asian bonds," said Richard Zhang, assistant chief executive officer at Huarong Investment Stock Corp, an international unit of one of four State-owned asset managers. He warned that in a crisis, structured notes using leverage would suffer greater losses.

China Citic Bank International Ltd and China Cinda Asset Management Co are among Chinese finance companies tapping the market for capital securities following a lull, just as anemic economic growth erodes their profitability. The Basel-based Bank for International Settlements said earlier this month that a warning indicator for the nation's banking stress had risen to a record, while CLSA Ltd estimated shadow banking activities may be hiding potential losses of $375 billion. China's money-market rates are forecast to remain elevated in the coming quarter, as the central bank seeks to rein in leverage.

UBS helped Elm issue 332 million yuan of three-year notes in January linked to lenders' contingent convertible notes, or CoCos, paying a 15.1 percent coupon. Yields on CoCos from Industrial & Commercial Bank of China Ltd dropped to a record low 3.7 percent last month as global interest rates slumped. The average yield on wealth management products sold by China's domestic banks declined 71 basis points in the first half to 3.98 percent.

The rally in China's CoCos has faded in recent weeks as the largest five lenders reported the smallest increase in trailing 12-month profits in at least a dozen years. The yield premium for ICBC's 6 percent additional Tier 1 securities widened 36 basis points to 312 basis points from the year's low on Aug 16.

Investors in structured notes can't afford major market corrections because the securities have deleverage triggers, forcing the sale of underlying CoCos should their prices fall too far.

Bloomberg