China bond market feels tail wind from monetary stimulus
10-year government bond yield slid to 3 per cent, a rally equivalent of Shanghai Composite trading at 5,000 points, analyst said
A fresh round of monetary easing has fanned China’s already-sizzling bond market and provided some respite to leveraged capital that some observers warn could be the source of the next market bubble. The central bank’s double-cut on interest rate and bank reserve requirement ratios last Friday has cheered fixed-income investors. Yields for the benchmark 10-year government bond dropped by 8 basis points to 3.01 per cent in the two and half trading days after since the rate cut, well below the historical average of 3.64 per cent. The seven-day interbank repo rate, which measures the cost to borrow government bonds, slid by 10 basis points to 2.34 per cent on Tuesday, having dropped 20 basis points to to 2.26 per cent on Monday, .
Several mainland China based fixed-income analysts were buoyant at the bond market rally in the wake of the rate cuts, predicting the seven-day repo rate will fall to around 2 per cent and stay there for the rest of the year, paving the way for bond yields to drop further.
“The bull run is far from over in the context of falling [consumer price index] and money market rates. The dearth of available assets to allocate continues,” CICC analysts led by Chen Jianheng said in note. “The 10-year government bond yield will fall through the 2.7 per cent trough seen in 2008 for the next few months, and would touch 2.5 per cent for the first half of next year,” Chen said.
In a seminar held by China Bond, a publication owned by the China Central Depository & Clearing, Li Yong, who heads the fixed income department at Essence Securities, likened the 3 per cent 10-year government bond yield with the 5,000 point level in the Shanghai Composite Index, the height of the rally in the market before it tanked from the middle of June.
China’s bond market, the third biggest in the world, has been bolstered by the stock rout and the wild swings in trading throughout the summer and into autumn. Skittish investors sought shelter in bonds. Coupled with waves of deregulation on corporate bond issuance, the bond market has seen exponential growth, with new issuances surging 70.8 per cent in the first three quarters of 2015 from the same period last year to 15.1 trillion yuan.
In September, new issuance in the interbank bond market, which accounts for 90 per cent of the entire bond market, rocketed 121 per cent to 2.3 trillion yuan.
The bull run has primarily been supported by pledged repos in which investors pledge notes for funds to double down on more notes and return the borrowed funds on another day at the market rate. Commercial banks’ wealth management funds, under pressure to hunt for yields, have been the main driver of leverage in the market’s surge, analysts say.
“Wealth management products have to deliver the returns they committed to investors. But as bond yields inch down, they have to seek unconventional ways to reach that target, such as channelling the funds to other mutual or private funds to leverage it up to make punts,” said Xiang Feiyan, fixed-income analyst at Qilu Securities, who urged investors to take advantage of the PBOC’s easing window to start winding down their leverage.
“Leverage is the only way to secure the required profit. But if the economy recovers which means monetary expansion will ease off, or a solid recovery in equities that siphon funds off from bonds, either scenario will jolt the bond market. Investors should take caution and start the deleveraging process now. Don’t be too greedy,” she said.
An equities rebound is like the proverbial sword of Damocles hanging over the bond market. When the A share market staged a mild rally in the middle of October, the repo rate in the exchange-traded bond market spiked sharply to 5 per cent several times.
“Investors should take note of fund flows behind the spikes in the exchange repo rate,” said Sun Binbin, chief fixed-income analyst at China Merchants Securities.
Sun predicted that the October average repo leverage ratio, calculated as dividing total bonds in custodian hands by subtracting between total bonds and outstanding repos , would exceed the height seen before the stock market crash. The ratio stood at 1.34 times in September and 1.38 in June.