Chinese bonds may be shaky as equities go into swoon
While uncertainty grows over corporates' losses in the equity market, huge municipal issuance after the swap programme has driven up yields
With stocks plummeting, money rates rising and the yuan facing uncertainty, Chinese investors are fleeing to the one corner of financial markets still standing - long-dated bonds.
However, China's long bonds may be less of a sure bet than an aggressively easing central bank and weak growth would usually imply. Corporate debt may do better, but many Chinese corporates own domestic stocks and in many cases the extent of their losses remains unknown.
For official debt, the problem is the massive local government refinancing operation kicked off in May to help city governments swap bank loans and other high-interest debt for new municipal bonds.
This has prompted a 36 per cent rise in interbank bond issuance for the year to July, driven largely by the swap programme, which was expanded by 1.2 trillion yuan on August 27 to 3.2 trillion yuan for this year. To throw that in relief, the total outstanding value of China's treasury bonds is only 9 trillion yuan.
This huge issuance has pushed yields higher and, although municipal yields fell after the central bank's latest rate cut on August 25, they are still up by nearly 50 basis points since the first 2015 issuance in May.
"Given that [municipal] bond issuance this year is now up to 1.4 trillion yuan, it's not surprising that banks are saying 'we've swallowed enough of this, you need to give us higher yields or more liquidity'," said Oliver Barron, the head of research at consultancy NSBO in Beijing.
Long-dated treasury yields also remain just a few basis points below where they were in February, despite four rate cuts since then, with analysts and the central bank blaming huge municipal issuance.
Flows into China's bond funds accelerated sharply in July as investors continued to flee stocks.
However, a hoped-for surge of foreign interest in long bonds after a relaxation of controls may have been damaged by the government's heavy-handed intervention to prop up equities.
"Chinese municipal bonds offer relatively good yields compared to many international fixed-income products, and I think the hope is that eventually foreign demand will be very strong," said Mao Saifeng, an associate director at Fitch Ratings in Hong Kong.
"But in the long run, people will ask the question, 'If I want to sell, will there be a market to do that?'"
Opaque price discovery mechanisms for mainland municipals, many of which have been placed privately and are thinly traded, also worry offshore investors.
"I wouldn't touch those," a portfolio manager at a Japanese investment firm, which operates a bond-focused China fund, said of the new municipal debt.
Nonetheless, parts of the onshore bond market may offer good value as domestic cash deserts stocks.
Sticky government bond prices mean corporate yields may have less room to fall than would otherwise be the case. But AA-rated corporate yields are still down about 30 basis points since June.
Corporate debt issuance this year has also been relatively subdued, meaning a far more favourable supply-demand balance than for municipals.
"Currently, we're mostly in large-cap corporate debt," said the portfolio manager at the Japanese fund.
Ironically, a big beneficiary of the stock crash has been bonds issued by local-government financing vehicles, the semi-official off-balance-sheet fundraising companies that the new municipal bond market was meant to replace.
Yields on AAA and AA-rated five-year debt issued by these vehicles are down about 40 basis points since June as a more permissive government stance on these firms and the stock sell-off have renewed investor interest.
That was despite a fourfold increase in such issuance since February, said Nicholas Zhu, a senior analyst at Moody's Analytics.
Swaps are another area where good opportunities still lie. Since May, offshore interest rate swaps have been trading 20 basis points below the onshore rate, probably in part due to the stock rally draining liquidity out of fixed-income products.
"As offshore [interest rate swaps] are still about 20 basis points lower, onshore fixed-income products have big room to catch up," said a trader at an Asian bank in Shanghai.