Oct. 16 (Bloomberg) -- Investors are signaling China’s debt rating is too low for an economy set to overtake Japan as the second biggest, driving up returns on government and corporate securities.

Contracts to insure China’s bonds are less expensive than those for Greece, Ireland, Spain and Italy -- each deemed at least as safe by Moody’s Investors Service, Standard & Poor’s or Fitch Ratings, after being pricier in 2008. They also are cheaper than all but four of 39 emerging-market credit-default swaps tracked by Bloomberg, including Israel and Abu Dhabi, which have the same or higher international-debt ratings.

A JPMorgan Chase & Co. index of dollar-denominated Chinese government and corporate debt is up 27 percent this year after posting its best three quarters since the measure was created in 2005, as China’s $3.9 trillion economy led the recovery from a global recession. Germany’s Union Investment and Japan’s Mitsubishi UFJ Asset Management Co., which together manage more than $280 billion, are betting on China government notes while Western Asset Management in the U.S. is buying debt sold by property developers and gas utilities.

“China is the biggest winner to come out of the financial crisis,” said Sergey Dergachev, who works on emerging markets for Union Investment in Frankfurt, which oversees about $230 billion in assets as Germany’s third-biggest money manager. “It will probably be upgraded next year.”

Lower Premium

It costs 67 basis points, or $67,000 a year to protect $10 million of China’s bonds, 21 points more than for Japan’s debt, which is rated two levels higher. That premium is down from this year’s 69-point average and about the smallest since January 2008.

China’s 4.25 percent euro bonds due in 2014 have returned 12 percent this year, the most since they were sold in 2004. They gained 5.1 percent in all of 2008 and 7.2 percent in 2005, the best full year so far, data compiled by Bloomberg show.

Demand for the bonds has narrowed the spread to Italy’s bonds to 27 basis points, or 0.27 percentage point, from 1.76 percentage points in October, the month after the collapse of Lehman Brothers Holdings Inc. prompted investors to dump emerging-market debt. Dergachev bought the bonds about six months ago and predicts the yield will fall below Italy’s.

Investors would earn 4 percent should demand increase enough to lower the current 3.14 percent yield by 27 basis points in a year, data compiled by Bloomberg show. By comparison, investors have lost 3.1 percent on U.S. Treasuries so far in 2009, Merrill Lynch & Co. indexes show.

Reserves

China has the world’s largest currency reserves at $2.27 trillion and debt equal to 20 percent of gross domestic product, compared with 219 percent for Japan and 116 percent for Italy. The three main ratings companies say China’s record increase in lending and reliance on government spending to drive growth offset those advantages.

“It’s not as obvious as it may seem to some investors that China is a slam-dunk, double-A country,” said Thomas Byrne, a Singapore-based senior vice president at Moody’s, which rates the country A1, four levels below its top Aaa. “Their banks have injected so much credit in a short time,” he said in an Oct. 12 phone interview.

Ratings companies say China’s economic growth masks weaknesses because it has been sustained by a $586 billion government stimulus package and record new loans this year of $1.3 trillion. The country’s GDP will expand 9 percent in 2010, versus 1.7 percent for Japan, the Washington-based International Monetary Fund predicts. China’s economy will grow to $5.3 trillion, surpassing Japan’s output of $4.7 trillion, IMF figures show.

‘Weakness Lurking’

Moody’s is evaluating whether there is “weakness lurking in the banking sector” after the lending jump, Byrne said. Kim Eng Tan, an S&P analyst in Singapore, said China’s stimulus may spur an increase in local-government debt.

“China’s reported financial attributes do appear strong,” he wrote in an e-mailed response to questions. “However, these have to be balanced against less obvious but important weaknesses.”

Fitch isn’t “contemplating” an upgrade until the nation’s exports recover, James McCormack, the head of sovereign debt ratings for Asia and the Pacific in Hong Kong, said in an interview. Exports fell at the slowest pace in nine months in September, dropping 15.2 percent from a year earlier to $115.9 billion, according to the customs bureau.

‘Good News’

“A lot of the good news supporting China is pretty much all priced in,” said Kenneth Akintewe, who helps manage $138 billion at Aberdeen Asset Management Plc in Singapore. “The eternal question now is: How much further can it go?”

Aberdeen said the best opportunities are in China’s local- currency debt market, which the company is awaiting a license to access.

“China is talking about more currency flexibility, but talk is one thing, and it would be nice to see some more meaningful action,” he said.

Speculation about an upgrade comes as China starts to open its local-currency debt market to global investors.

The government has five bonds denominated in dollars, one in euros and one in yen. Five of the six for which Bloomberg has data have produced profits this year for an average return of 2.7 percent, with three outpacing 2008’s performance.

The nation’s overseas bonds total $4.3 billion, less than a fifth of the Philippine government’s $22 billion in outstanding foreign securities. Including corporate bonds, China has $43.5 billion of international debt as of June, according to the Bank for International Settlements in Basel, Switzerland.

Foreign Investors

As of September, 78 foreign entities, including UBS AG and Morgan Stanley, were permitted to invest another $15.7 billion in local-currency debt and stocks, according to China’s State Administration of Foreign Exchange data. China has said it plans to increase that to $30 billion with additional investment licenses.

The government denies foreigners access to the rest of its yuan-denominated bonds, which totaled the equivalent of $1.35 trillion in March, almost double 2006’s year-end sum, BIS figures show.

China plans to complete its first auction of yuan bonds in Hong Kong this month, to raise the equivalent of $880 million. Demand has been “quite strong,” said Tse Kwok Leung, head of the economic research division at Bank of China Ltd.’s Hong Kong branch. Bank of China, the nation’s third-largest lender, and mainland financial companies also have sold the equivalent of $4.7 billion in local-currency bonds in Hong Kong since July 2007.

Lower Costs

China’s foreign-currency debt was upgraded to its current levels of A1 by Moody’s in July 2007, A+ by Fitch in November 2007 and A+ by S&P in July 2008. Japan is rated Aa2, AA and AA, respectively.

Since China’s last upgrade, the cost of insuring its bonds has fallen from as high as 2.90 percentage points in October to today’s 0.68 point, the sharpest drop since the contract started trading in 2003. Initially created to protect against defaults, swaps also are used to speculate on credit quality.

DBS Asset Management, a unit of Singapore’s largest bank, said state-owned banks’ dollar debt is worth buying, including China Development Bank’s 4.75 percent note due in 2014, which yields 3.70 percent according to data compiled by Bloomberg. It also recommends seeking access to yuan bonds to profit from exchange-rate appreciation.

Currency Bets

“This year it has been fairly straightforward to make money from dollar credits,” said Desmond Soon, who helps manage about $21 billion at DBS Asset in Singapore. “Next year, the story will be migration towards currency bets.”

The median forecast in a Bloomberg survey of 18 currency strategists predicts the yuan will climb 3 percent to 6.63 by the end of 2010.

Demand for Chinese bonds will surge as the government opens the local market to overseas investors, said Hideo Shimomura, who helps oversee $55 billion as chief fund investor at Mitsubishi UFJ Asset in Tokyo, part of Japan’s largest bank. It now holds only Chinese and Hong Kong bonds denominated in U.S. and Hong Kong dollars.

“People will rush into the market because the currency might strengthen,” Shimomura said. “China is becoming almost the same as industrialized countries, so the rating must be upgraded.”

Upgrade Prospects

Rajeev De Mello, the head of Asian bonds in Singapore for Western Asset, is buying corporate debt to bet that China will sustain growth. He has bonds of Xinao Gas Holdings Ltd., the gas distributor partly owned by the World Bank, and Sino-Forest Corp., which operates forest plantations in nine Chinese provinces.

“The nation is definitely on track for an upgrade,” said De Mello, whose company oversees $513 billion of debt. “The government is pushing growth. That means a bigger infrastructure buildup.”

He also holds the debt of Agile Property Holdings Ltd., a Hong Kong-traded developer of real estate in China, and Galaxy Entertainment Group Ltd., which owns the StarWorld Hotel and Casino in Macau.

“The market for dollar corporate bonds is a very active, and we’ve seen trading volume up a lot this year,” said Doris Chen, a credit analyst in Hong Kong at SJS Markets Ltd., a brokerage based in the city that specializes in high-yield Asian debt. “There is still a strong interest.”

To contact the reporter on this story: Wes Goodman in Singapore at wgoodman@bloomberg.net; Lilian Karunungan in Singapore at at lkarunungan@bloomberg.net.

Last Updated: October 16, 2009 02:19 EDT