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SHANGHAI/SINGAPORE (Reuters) – China’s promise of a “comprehensive” package to address local debt issues has triggered a rush into bonds issued by local government financing vehicles (LGFV) as investors sense an implicit state guarantee for these provincial firms.
Yields on LGFV bonds, which account for half of China’s corporate bond market, have dropped to their lowest levels this year, even as a debt crisis in the property sector that most of them are exposed to deepens.
Data from Chinabond, a platform that’s part of the China Central Depository and Clearing, shows spreads on one-year AA- rated bonds over comparable government bonds, have dropped from 353 basis points (bps) at the start of the year to around 173 bps, the smallest gap since late 2020.
The narrowing of spreads is more pronounced in lower grade LGFV bonds, despite growing signs of fiscal stress for local governments, whose primary source of income is from infrastructure and land sales, both of which are sputtering.
LGFVs’ $9 trillion debt pile – including loans, bonds and shadow credits – are seen as a growing source of systemic risk in China’s financial system, especially with the economy in such weak shape.
But investor confidence in the country’s roughly $1.9 trillion worth of LGFV bonds returned after China’s July Politburo meeting at which top policymakers indicated an intent to develop a comprehensive scheme to resolve local debt risks.
Details were sparse, but economists say measures could include debt swaps and restructuring.
“Our LGFV positions have increased compared with the beginning of the year, and the duration of those assets has also been slightly extended,” said Zhu Yangmo, a partner at Hainan Shanze Asset Management.
The risk of investing in LGFVs also has decreased as local governments seemed to be actively resolving hidden debt issues, Zhu said.
In the meantime, as the economic recovery falters and property sector problems ensnare more developers such as Country Garden Holdings, investors have dumped private property developer bonds. Yields on one-year real estate bonds rated AA- have widened 220 bps in the past month, data from Chinabond shows.
That divergence reflects investors’ expectations that Beijing will support LGFVs in order to minimise financial contagion, despite rising delinquencies among developers.
The demand has also meant LGFVs accounted for 63.9% of the non-financial credit products in the top 10 holdings of wealth managers as of the second quarter, up 3.7 points from the first quarter, analysts at China International Capital Corp (CICC) said in a report.
Yields on LGFV bonds issued in August averaged around 3.9%, the lowest seen this year, according to data provider Dealing Matrix(DM).
“I was surprised the yields of new issuances were this low and our chance of winning the auction was not high,” said a Shanghai-based trader working at a large asset manager.
Even in Tianjin, one of the most heavily-indebted cities in China, commercial paper issued by the Tianjin Infrastructure Investment Group rated AAA by China Lianhe Credit Rating was oversubscribed 43.4 times, pushing the borrowing cost down to 4.5%. A previous issue earlier in August was at 6.16%.
The chorus of economists calling for China to support LGFVs as part of measures to shore up the economy has grown.
Chi Lo, Hong Kong-based senior economist at BNP Paribas (OTC:BNPQY) Asset Management, said Beijing needs to refinance LGFV debt over the next three to five years to prevent the system from imploding.
In the worst-case scenario, China’s central bank may step in, “monetize the debt, print money, buy up those debts, then things will be fine, at least in the short term,” he said.
