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Saturday, 19 April 2014

BONDS: Yields show China banishing doubts over municipal debt

(Reuters) For all the anxieties over China’s mountain of local government debt, the recent performance of the country’s municipal bonds shows that domestic investors see little risk of default.

Source: Reuters

An ethnic Uighur woman (R) collecting bricks at a demolition site which will make way for a residential complex in Akqi county in Xinjiang Uygur Autonomous Region June 5, 2012. Government projects have left China with a Rmb10.7trn (US$1.7trn) mountain of local government debt, just as growth is slowing.

So-called “city investment bonds” are, on average, trading above their issuance price, a Reuters analysis shows, while spreads between lower credit-rated paper and risk-free benchmarks have narrowed.

Trends indicate local investors are less nervous about local government debt than they were earlier this year, even as the PRC’s economy has slowed sharply and a chorus of China bears point to local debt as the possible trigger for a hard landing scenario.

Although the PRC’s onshore bond market is mostly closed to foreign investors, yields on municipal bonds offer a window on how Chinese investors assess the risk of a local government debt meltdown.

The increased confidence is a result of recent policy moves and actions that show local governments can be counted on to guarantee paper issued on their behalf by off-balance-sheet financing companies.

Of 340 city investment bonds Reuters has identified, 209 trade at or above par value, while only 14 bonds trade at a discount of more than 5%.

The weighted-average yield on the bonds Reuters identified was 6.10%, compared to an average yield at issuance of 6.13%.

That compares to a risk-free benchmark yield of 2.76% on five-year Chinese central government bonds, whose maturity matches the average of the bonds Reuters analysed.

Even though required reserve-ratio and interest-rate cuts in May, June, and July contributed to falling yields, the narrowing of spreads against safer government bonds shows that investors now see less risk for lower-rated paper, including municipal bonds.

Debt binge

Local governments went on a borrowing spree to fund infrastructure projects during China’s economic stimulus plan in 2008-10. Estimated at Rmb10.7trn (US$1.68trn) at the end of 2010 in an official audit, outsiders reckon local debt could be far higher.

The lion’s share of their borrowing occurred through bank loans, but Reuters estimates that Rmb464bn in municipal bonds is currently outstanding. Authorities took initial steps to restrict further borrowing in mid-2010 and were still restricting new issuance as recently as April this year.

Unease over the debt stemmed in large part from ambiguity over who was ultimately liable. China’s budget law forbids localities from issuing bonds directly, so they established arms-length financing companies (LGFCs) to issue bonds or take out loans.

With many such companies not generating the cash flow necessary to service the debt, investors wondered if local governments would stand behind them, despite the lack of an explicit guarantee.

Earlier this year, however, the central government told municipalities that they should be ready to intervene, if needed, to avoid a default.

“Central authorities began to signal clearly that local governments were expected to take responsibility for the debts of these investment companies,” said Wang Haoyu, economist at First Capital Securities in Shenzhen.

There have been a couple of cases since April where municipalities have done just that.

Reassuring

Concerns over the lack of security posed by these LGFCs faded in April, when a technically insolvent textile company Shandong Helon was saved from default on Rmb400m in commercial paper at a last minute with a bailout from the local government of Weifang city.

Weifang’s rescue of Helon, not a LGFC, but of which the local government owned 16%, left little doubt how a similar scenario involving a wholly owned LGFC would be handled, said a bond trader at a European bank in Shanghai.

“City investment bonds look good to a lot of people because the yields are high, even though no one thinks a default is possible”

“At that moment, a lot of the concerns about local government financing vehicles diminished. Sentiment shifted over whether a state-owned company defaulting was possible,” he said. “There is no doubt the local government will bail out as a last resort.”

The notion that even mid-sized companies will get too-big-to-fail treatment from local governments was reinforced last week, when the government of Xinyu city, in Jiangxi Province, announced it would use taxpayer funds to repay the loans of LDK Solar, a US-listed solar equipment manufacturer.

Judging by spreads on riskier bonds, Chinese investors clearly have gained confidence in recent months.

Showing how the risk premium has fallen, the spread between five-year enterprise bonds, rated AA ,and five-year government bonds peaked at 459bp in February, before narrowing to 339bp as of July 24.

Although it also includes other issues from unlisted state companies, the set of AA rated enterprise bonds contains many city investment paper.

At 6.16%, the yields on this set of bonds also closely match the average yields of the city investment bonds that Reuters analysed.

Attractive yields

As China’s yield curve has collapsed in the wake of interest rate cuts in June and July, the risk-reward profile of these bonds now looks attractive to investors searching for yields.

“City investment bonds look good to a lot of people because the yields are high, even though no one thinks a default is possible,” said a Chinese fixed-income fund manager at a Sino-foreign joint-venture fund company.

The products have become popular with fixed-income mutual funds, as well as wealth management products sold through commercial banks.

Investors should still beware of the bonds’ often poor liquidity, and a fund seeking to sell on short notice might have trouble getting a decent price, analysts and fund managers said.

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