Default Fears Make Some China Local Bonds Lemons of Market

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Bloomberg News
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Bloomberg News

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(Bloomberg) -- The borrowing units set up by China's local governments in the wake of the global crisis have long been a bugbear for national policy makers in Beijing. Now, rising fears of defaults are making their debt the ugliest part of the world's third-biggest bond market.

That's the consensus of 22 Chinese bond traders and analysts surveyed by Bloomberg last week -- none of whom are positive about the local government financing vehicle sector in the fourth quarter. Some 18 respondents said LGFVs, which help finance roads, bridges and sewers, will have to pay higher coupons to obtain yuan financing.

The sentiment echoes the views of Fitch Ratings and Moody's Investors Service, which recently said payment failures among the LGFVs are becoming more likely. Outstanding notes from the sector has ballooned to 4 trillion yuan ($601 billion) and there could be "pockets of risk taking and debt hiding,” Fitch said in a Monday report. The bearish views also came after local governments in April were ordered not to provide any guarantees to back certain types of borrowing, including LGFVs. Reduced support would make the debt riskier.

“It's likely more LGFV bonds will pay higher coupons in the fourth quarter,” said Wang Yifeng, a Beijing-based analyst at China Minsheng Banking Corp.'s research institute. “The quality of LGFV issuers has come down a lot, therefore risks for those new issues are rising.”

Some 26 LGFV bonds were sold at coupons of at least 7 percent in the third quarter, compared with just 12 in the first half of the year, according to data compiled by Bloomberg. Jiangsu Hanrui Investment Holding Co., builder of an economic development zone in the eastern province of Jiangsu, sold 1 billion yuan of 270-day bills last month to yield 6.8 percent. That matched the highest coupon on record for similar-maturity LGFV notes.

Another sign of stress can be seen in a surge in issuance of shorter-tenor securities by these issuers. Onshore sales of debt maturing in less than a year reached 185.7 billion yuan over the six months through September, up 29 percent from the six months through March, Bloomberg data show.

READ: China Cities Face Surging Funding Costs on Default Concerns

More than three quarters of the survey respondents expect more LGFV bonds to price at coupons of 7 percent and above. The average yield on seven-year LGFV bonds that are rated AA- has risen about 109 basis points so far this year, set for the sharpest increase since 2011. It's little more than a quarter point from the two-year high of 6.73 percent reached in June.

Further findings from the Bloomberg survey:

Investors are most bullish on higher-quality corporate bonds, with 36 percent of respondents seeing those as the best performing next quarter; such securities typically have AAA ratings from domestic agencies
- Government and policy bank bonds came second, at 27 percent, and negotiable certificates of deposit third, at 23 percent
- 9 percent of the respondents are positive on lower-rated corporate bonds
82 percent of respondents believe corporate bond sales will rebound in the fourth quarter
- Corporations sold 2.2 trillion yuan of bonds onshore in the third quarter, up 37 percent from the previous three months, according to Bloomberg-compiled data
- Some 55 percent say spreads on corporate bonds over government debt will widen in the fourth quarter, while 41 percent think premiums will stay flat