• Once destined for the policy dustbin, chengtou bonds are once again in favour with both the government and investors. Issuance is surging, ratings are improving and maturities are lengthening.
  • After a string of failures in the bond market starting in the second half of 2015, overall credit risk is receding, not because issuers are in better shape, but because the government has signalled the limits of its appetite for defaults, strengthening the moral hazard that has driven yields to multiyear lows.
  • Liquidity risk nevertheless remains, though even if a liquidity shock turns this bond bull market to bust, chengtou bonds will remain supported because of their perceived protection.

Chengtou bonds, which are bonds sold by China’s local government financing vehicles (LGFVs), have undergone a resurgence since they were saved from the policy dustbin last year.

The Chinese bond market continues to boom, underpinned by a belief among investors that the government will bail them out in the event of failure. In the event of a liquidity or credit shock, we expect chengtou bonds would emerge relatively unscathed, because official signals suggest their implicit government backing may actually mean something.

Policy U-turn

The central government started to clamp down on issuance of chengtou bonds in the second half of 2014 as part of its clean-up of local government finances. They were originally sold by companies controlled by local governments, who were bypassing legal prohibitions on selling bonds directly to the market. Sales fell through the start of 2015 as a result of tighter issuance rules, but also because authorities began to allow direct local government sales (see chart).

The crackdown did not last. China’s economic slowdown prompted a government U-turn in the second quarter of last year, when the National Development and Reform Commission relaxed its policies on bond sales by LGFVs. In the first quarter of this year, Rmb765.3bn ($115bn) of chengtou bonds were sold, the highest quarterly figure for gross issuance on record. The most recent quarterly tally, which may have been impacted by the local government bond-swap programme, was still up more than Rmb40bn on the same period last year. By the end of July 2016, outstanding chengtou bond value was Rmb6tn, up from Rmb4.2tn at the end of 2014.

Thumbs up from the market

The central government’s U-turn — effectively removing policy risk — has been recognised by domestic rating agencies and by investors in turn. To the extent that domestic ratings mean anything, the proportion of chengtou bonds receiving investment grade or higher ratings has been 6.9 per cent higher this year than in 2015. AAA-rated bonds account for nearly 30 per cent of chengtou bonds rated this year, up from 16.8 per cent in 2014 (see chart).

We expect ratings on these bonds to improve further, helped by a programme that allows local governments to sell bonds to pay down other debt. This programme was originally intended to retire outstanding bank loans, but is thought to have expanded to other forms of debt, including chengtou bond payments.

Investor approval is also reflected in the lengthening maturities on these bonds. The proportion of outstanding chengtou bonds in the form of commercial paper with durations of up to one year has fallen to just over 20 per cent this year from 26.6 per cent in 2015.

Stability, stability, stability

The rally inchengtou bonds has been underpinned by a belief that these bonds are, now more than ever, implicitly backed by their local government issuers. The central government has done little to disabuse investors of the notion that the state will make good on their bond holdings.

After months of ructions in the bond market over growing defaults, the state-owned Assets Supervision and Administration Commission said this week it would try to avoid bond failures to maintain financial market stability. The agency was referring to bonds issued by the 104 central government companies over which it had direct oversight, but the message was clear: authorities’ tolerance for defaults had strict limits following the string of failures that rocked the market from late 2015.

This strengthening of moral hazard is reflected in plunging yields (see chart). The yield on 10-year government bonds fell in August to its lowest level since April 2002, driven by expectations of yet more stimulus to support flagging economic growth. But corporate, enterprise and chengtou bond yields have followed, and the spreads between them have essentially collapsed.

Liquidity risk now the main threat

But investors are getting nervous about the liquidity and leverage fuelling this rally. Interbank market borrowing costs jumped on Wednesday after the People’s Bank of China provided 14-day funding during its daily open market operations.

The central bank had not offered this duration of reverse repurchase agreement since February, and this could mark the beginning of a strategy to limit the shortest-term interbank market borrowing, which is being used for bond purchases. Monthly turnover of repurchase agreement trading in the interbank system — a gauge of leverage activity in the bond market — hit a record high of nearly Rmb60tn in July (see chart).

However, given that the government has made it clear that it now sees chengtou bonds as a necessary and important component of local government financing as regional economies slow, we expect them to fare better than other kinds of corporate bond in the event of any meaningful clampdown on speculation in the bond market.

We estimate that Rmb1.1tn of chengtou bonds will mature in 2016, up 34.4 per cent from last year, including Rmb327.6bn in the fourth quarter alone. Yet, despite this increase in maturity pressure, the shift in the political and economic winds means the risks facing these bonds have substantially diminished.

FT Confidential Research is an independent research service from the Financial Times, providing in-depth analysis of and statistical insight into China and Southeast Asia. Our team of researchers in these key markets combine findings from our proprietary surveys with on the ground research to provide predictive analysis for investors.
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