Debt issues back in focus as economy slows down
Local government bonds flourish as limited availability triggers demand from investors
The renewed focus by leaders at the national level on “stabilizing economic growth” has brought local government financing vehicles back from the brink of extinction.
Just weeks ago, many observers believed that such off-balancesheet debt issues would soon be a thing of the past. Now, issues are expected to accelerate for the rest of this year, and even older LGFV securities are being snapped up by yield-hungry investors — even as a wave of on-balance-sheet municipal bonds starts to hit the market.
The prices of notes issued by LGFVs, created to sidestep a longstanding ban on direct debt issues by local governments, are rallying as these securities become scarcer in the market and the higher yields they offer become tougher to find.
The total return of a debt instrument is the price change plus the yield. Prices and yields move inversely in the secondary market.
As investors have become more confident in the security of LGFV debt repayments, they have become willing to pay higher prices for these securities. That factor has driven down the yields of the debt, but they are still higher than those for other comparable securities.
So far this year, the yield premium on three-year AA-ranked LGFV notes has narrowed by 37 basis points to 2.13 percent, according to Chinabond.com. The current yield on three-year sovereign debt is 2.86 percent, while the current yield on the AA-rated LGFV debt is 4.99 percent. Municipal bonds’ average coupon rate, by comparison, is 3.17 percent for a three-year bond.
Yet LGFV debt has become scarce. As authorities clamped down on such borrowing last year, issues plunged to 80.35 billion yuan ($12.95 billion) in December, from a 266.9 billion yuan peak in April, according to financial data provider Wind Information Co Ltd.
The issue drought lasted into this year, with sale of new securities amounting to 498.9 billion yuan in the first five months, compared with 885 billion yuan the same period last year, according to Wind data. In February, the figure sank to a record low of 27.65 billion yuan, just one-quarter of the year-earlier total.
Investors were unnerved by a State Council document in October that banned LGFVs from raising debt on behalf of local governments. The cabinet’s statement said that authorities have no obligation to repay debt that was not assumed for public works.
Regulators approved far fewer issues after that document, most of which were by entities that had previously obtained debt quotas before October. New project starts also plunged.
The scarcity saw the yield premium on three-year AA-rated notes widen by a record 89 basis points over the sovereign in December.
The fall in issue volume coincided with GDP growth falling to a six-year low of 7 percent during the first quarter. Concern that the economy might be in a free-fall prompted national policymakers to keep the investment engine humming.
Analysts said the situation convinced the National Development and Reform Commission, the top economic planner and regulator of State-owned enterprises’ bond issues, to ease the rules in late May. To deter China’s 10,000-plus LGFVs from indulging in their insatiable urge to borrow, the NDRC earlier imposed limits on bond issues such as annual ceilings.
Municipal bond yields aren’t attractive for funds.” Zhang Xue, fund manager at Morgan Stanley Huaxin Fund Management Co
These requirements were quietly eased a couple of weeks ago.
At least three Chinese brokerages forecast that the supply of new LGFV notes will surge later this year. China International Capital Corp said that because it takes about two months for issuers to prepare filings, the effect of the NDRC easing would not be seen until the third quarter.
The dearth of fresh supply has made the increasingly rare legacy bonds more appealing to investors.
“Municipal bond yields aren’t attractive for funds,” Zhang Xue, a fund manager at Morgan Stanley Huaxin Fund Management Co, told Bloomberg News. “If everyone thinks there’s an implicit guarantee over these LGFV bonds and credit risks aren’t high, there’ll still be demand.”
A seven-year AA-rated LGFV bond from Jiangxi was issued in late May at a 5.5 percent coupon, the lowest among similar bonds issued this year, showing the product’s popularity.
However, the NDRC easing does not mean a return to “business as usual” situation that prevailed before the document in October.
The NDRC document specified that new bonds from LGFVs cannot be regarded as “government debt”, meaning they cannot be repaid from the official budget. A line was drawn between corporate credit and government credit, at least in theory.
That was a step toward a recent International Monetary Fund call for China to break “the web of implicit guarantees” and strengthen corporate governance among SOEs. But reality in China is far more complicated.
“If the bonds that aren’t included in the official budget run into repayment difficulties, it’ll signal the beginning of localgovernment defaults,” Xu Gao, an economist at Everbright Securities Co, said. “Investors will abandon all local-government debt, causing a systemic financial crisis.”
Financial analysts said there was little chance that the government would let that happen.
A report by Industrial Securities Co Ltd said that compared with high-rated LGFV bonds, lower-rated ones are viewed more favorably because they are thought to enjoy implicit guarantees. Old bonds are safer because they are more likely to be categorized as “government debt”.
Zhou Yue, an analyst with China Merchants Bank Co Ltd, said that investors will increasingly have to evaluate credit risk on individual bond basis.
Zhou said that while municipal bonds will finance most public projects that do not offer high returns, such as water, bus services and subsidized housing, LGFV bonds will still be necessary to fund infrastructure projects such as toll roads and industrial zones.
For the time being, it seems, the two types of debt will co-exist.