Traders Are Worried About China Local Government Debt Again

(Bloomberg) -- The scent of doom is returning to China's local government bond market.

S&P Global Ratings pulled the trigger on the first ever downgrade of a Chinese local-government financing vehicle Thursday, citing the city in eastern Jiangsu province's high debt burden. Traders and analysts are uneasy as well, with 18 of 29 polled in a Bloomberg News survey saying they'd sooner buy corporate debt than LGFV bonds.

Concern Beijing is trying to wean local bodies off their support is quelling demand for the debt, with the yield premium on LGFV notes versus company bonds swelling to near the most since March 2014.

“Now, we can't buy LGFV bonds with our eyes closed,” said Deng Rui, chief investment officer for fixed income at Changjiang Securities Co. in Beijing. “We have adjusted our portfolio to start buying more corporate bonds.”

This new-found anxiety is a blow to a market that had started to recover in 2016 from the liability web that entangled local governments and their financing vehicles after 2008. Despite not seeing any defaults, LGFV bonds became the poster children for China's ballooning debt problem. For many investors, the debt is symbolic of the country's excesses in the wake of the global financial crisis, when municipalities -- barred from issuing bonds on their own -- used the vehicles as a way of meeting funding shortfalls.

In 2015, Beijing stepped in with a new budget law and debt swap program to ease the LGFV debt burden. But that support can no longer be assured.

Local governments aren't responsible for repaying debt issued by their financing arms or other state-owned companies, the Ministry of Finance said in a statement Nov. 4. S&P interpreted this as China signaling there won't be direct bailouts. LGFVs are facing funding hurdles both onshore and offshore this year because of the shift in government policy, according to Ivan Chung, head of Greater China credit research at Moody's Investors Service.

Maturing Debt

The funding vehicles have 5.5 trillion yuan ($797 billion) of bonds outstanding, of which about 888 billion yuan matures this year, according to Bloomberg-compiled data. Domestic sales fell to 174 billion yuan last quarter, and overseas issuance was below expectations, with six sales of only $1.2 billion, versus 21 deals worth $5.3 billion in the fourth quarter.

There's likely to be more downgrades of LGFV ratings after S&P made the first move, according to Anne Zhang, executive director at the private banking arm of JPMorgan Chase & Co. in Hong Kong. Weak revenue growth amid persistently strong infrastructure investment by Lianyungang City was behind the one-notch cut to construction services provider Jiangsu NewHeadline Development Group's rating, S&P said Thursday.

The LGFV is owned by Lianyungang City. The financing vehicle's $300 million of 2019 notes fell 0.137 cents on the dollar Thursday, the biggest drop in a month. Lianyungang Port Group, another LGFV from the same city, is currently meeting investors over a dollar bond, people familiar with the matter said this week.

The spread between onshore LGFV bonds and other corporate notes will widen more this year, especially when it comes to weaker-quality financing vehicles, said Gao Zhigang, a fixed-income analyst at Tianfeng Securities Co. in Shanghai.

Support Fading

LGFV bond yields rose above those for corporate debt at the start of the year as investors became more confident about company earnings. Aggregate profits for China-listed firms grew 14 percent in 2016, up from 10 percent in 2015, according to Bloomberg data.

“Overseas investors are also growing more wary of the LGFV bonds sold in the offshore market,” said Chung from Moody's in Hong Kong. “This is because of their poor financials, and also because we are going to reach the end of the three-year swap program, which means government support is fading.”

Chinese authorities embarked on a local-government debt swap program in 2015, refinancing 15.4 trillion yuan of non-bond debt including LGFV obligations with municipal bonds.

People are worried the swap price for existing LGFV bonds will be lower than market prices, which has led some to exit early, said Zhang Xu, chief fixed-income analyst at China Everbright Securities Co in Beijing.

“My only concern is market panic if such transactions were to happen,” he said “Because there is no playbook, there is a lot of speculation on the swap price.”

--With assistance from Carrie Hong and Denise Wee

To contact Bloomberg News staff for this story: Lianting Tu in Hong Kong at ltu4@bloomberg.net, Xize Kang in Beijing at xkang7@bloomberg.net, Ling Zeng in Shanghai at lzeng30@bloomberg.net, Jing Zhao in Beijing at jzhao231@bloomberg.net.

To contact the editors responsible for this story: Neha D'silva at ndsilva1@bloomberg.net, Christopher Anstey at canstey@bloomberg.net, Beth Thomas, Emma O'Brien

With assistance from Lianting Tu, Xize Kang, Ling Zeng, Jing Zhao