China’s local govt bond risks flow to yield-hungry foreign buyers

Bonds issued by LGFVs hit the global market

HONG KONG, July 26, (RTRS): A combination of towering leverage, stunted cash flows and illusory guarantees could deliver a salutary lesson to foreign investors dabbling in the rising flow of bonds from Chinese local governments onto global markets.

Local Government Financial Vehicles (LGFVs), created by China’s local authorities to bypass restrictions on their borrowing, have so far this year issued $3.4 billion of high-yielding dollar-denominated bonds, within reach of the $4 billion record for the whole of 2015.

Nomura estimates the market for these bonds will triple to $30 billion by 2017 as China steps up infrastructure projects and Beijing’s determination to hit growth targets demands ever more credit.

That will constitute a growing proportion of the estimated 1 trillion yuan ($150 billion) of total LGFV bonds, as borrowers find it more costly to raise funds at home amid rising defaults.

In an era of ultra-low interest rates globally, top asset managers such as Schroder’s, Blackrock and PIMCO are snapping up these products in the hunt for yield, even though they are mostly guaranteed by asset-light offshore subsidiaries of local government entities.

The asset managers did not respond to requests for comment.

“China LGFVs have weak fundamentals — the leverage is high, cash flows are weak and onshore banks are becoming selective in their lending,” said Lombard Odier analyst Tracy Wang. She said banks’ reluctance to lend to LGFVs was one of the factors pushing them into bond financing. But weak cash flows has not stopped LGFV bonds from selling.

Beijing Infrastructure Investment and Guangzhou Metro Group, two LGFVs that manage urban transport systems, were able to sell global bonds even though at the current pace of cash generation it would take them 324 and 750 years, respectively, to repay their debt, according to DBS Group Research.

The investor appeal of LGFV bonds comes from expectations of government support in the event of a default, which secures investment grade rating for bonds that would otherwise be rated as junk.

Tianjin Binhai, which develops infrastructure in the Binhai new Area, would have been rated eight notches lower than

its A3 rating from Moody’s without the very high level of support from the Tianjin Government, according to Moody’s, which said in March the vehicle had a “weak standalone profile with little commercial

viability”.

When it launched its $500 million, five-year bond in 2015, Tianjin Binhai received orders for over $1.9 billion as investors were attracted by its pricing at

245 basis points over corresponding US Treasuries. But recent bond failures suggest the assumption of support has never looked more doubtful, as authorities appear increasingly willing to sit on their

hands when borrowers come unstuck.

In April last year, Baoding Tianwei Group failed to make an interest payment on a bond, the first time a state-owned firm had been allowed to default.