China Top Bond Fund Says Rout May Worsen Amid Leverage Curbs

(Bloomberg) -- It's been the worst month for China's local corporate notes in two years. And it might just be the start, as the nation's top bond fund manager says yield premiums could rise further in 2018.

President Xi Jinping is stepping up efforts to trim the world's largest corporate debt burden, after emerging even more powerful from the Communist Party's twice-a-decade congress in October. Financial institutions are hoarding cash amid expectations the government will announce more measures to curb leverage, and that is pushing up borrowing costs in the money market.

“There is a high probability that credit spreads will widen next year given that there hasn't been any improvement in the tight liquidity,” said Zhang Qinghua, general manager of fixed-income fund investment at E Fund Management Co. His E Fund Stable Value Bond-A fund has returned 15 percent, the best among fixed-income funds in China with more than 3 billion yuan ($454 million) of assets that are tracked by Bloomberg data.

Policy makers must walk a fine line. Bond market pain has already spilled over into equities, as rising borrowing costs tarnish corporate balance sheets. Economic growth could also be jeopardized if deleveraging sparked a rash of defaults. For now things appear under control. While two more firms missed bond deadlines recently, there have been only about 21 note defaults this year compared with 29 for all of 2016.

Still, the fallout from rising financing costs is clear. Sales of local corporate notes this year are set for the lowest level since 2014, according to Bloomberg-compiled data.

The average yield premium of three-year AAA corporate bonds over government notes has widened 30 basis points this month to 147.5 basis points, the biggest increase since March 2015. The Shanghai Interbank Offered Rate has jumped 31 basis points this month, the most since February.

Despite those market moves, the government is rolling out more deleveraging measures. Financial regulators this month proposed sweeping rules to curb risks in the country's $15 trillion of asset-management products.

Read more on forecasts for a rocky 2018 for China's corporate bonds

The government is still focused on preventing financial risks and curbing leverage, as economic slowdown looks limited, according to Zhang.

Closure of zombie companies may accelerate next year and some individual companies' credit events are unavoidable. However, overall credit risks are declining because of improving profits and declining leverage ratios, he said.

Convertible bonds will outperform government and corporate securities next year because listed companies' profit growth may remain high, boosting attractiveness of equity assets, according to Zhang. 

See more on Zhang's previous calls on convertible bonds

“Liquidity may also flow from the cooling property market to the equity market next year, supporting better performance of the equity market,” said Zhang.

To contact Bloomberg News staff for this story: Judy Chen in Shanghai at xchen45@bloomberg.net, Tian Chen in Beijing at tchen259@bloomberg.net.

To contact the editors responsible for this story: Andrew Monahan at amonahan@bloomberg.net, Richard Frost at rfrost4@bloomberg.net.

©2017 Bloomberg L.P.

With assistance from Judy Chen, Tian Chen