Carry Trades Supercharge Bond Returns for Chinese Fleeing Stocks

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Chinese investors, who rushed for the exits when a debt-fueled stock rally ended, are now ignoring worsening credit profiles to buy corporate bonds with borrowed cash.

A rally in five-year AA notes has cut their yield premium over the sovereign to the least since 2010, as trading on the interbank market surged 28 percent in July. With the overnight repurchase rate averaging 1.2 percent in the past two months and the yield on the riskiest Chinese bonds well over 5 percent, carry trades in which debt is bought with loans are attractive, says Shanghai CFETS-ICAP International Money Broking Co.

“The bond market’s performance will improve in the second half as funds seeking stable returns flow back,” said Guo Jun, a fund manager at Bosera Asset Management Co., which oversees 302.8 billion yuan ($48.8 billion). “In terms of investment strategy, one is to leverage up through carry trade.”

The rally is helping central bank governor Zhou Xiaochuan’s efforts to lower corporate borrowing costs as he balances the need to stimulate demand while avoiding the creation of more asset bubbles. Investors are plowing into corporate debt even as the number of borrowers hit by rating downgrades jumped 21 percent in the first half of this year amid the slowest economic expansion in six years.

Issuance Surge

Real-estate company Beijing Tian Heng Development Group sold AA rated five-year securities at 4.12 percent on July 22, lower than the 5.22 percent on similar debt in the secondary market. Onshore issuance of corporate bonds, government debt and certificates of deposit have surged to 10 trillion yuan so far this year, close to the 11 trillion yuan in the whole of 2014. The government is allowing provinces to sell debt directly to help refinance the debt of regional finance vehicles, many of which are rated AA.

Policy banks may sell at least 1 trillion yuan of bonds to fund construction projects, according to people familiar with the matter. The first batch will be 300 billion yuan, the official Xinhua News Agency-backed Economic Information Daily reported Wednesday, citing a document it said it obtained.

“As funds shift to the bond market from stocks, issuers are benefiting from the spike in demand,” said Wang Ming, chief operations officer at Shanghai Yaozhi Asset Management LLP, which oversees 4 billion yuan of fixed-income securities. “The fresh inflows helped to alleviate the pressure on the market amid huge supplies.”

Yields Drop

The yield on five-year AA rated bonds fell to 5.11 percent on July 24, the lowest since October 2010, and its premium over government notes dropped to 192 basis points on Aug. 3, ChinaBond data show. The yield on AA- notes declined to 5.31 percent on July 29, the lowest since November. Gradings of AA-or below are equivalent to non-investment ratings globally, according to Haitong Securities Co.

Declining yields don’t necessarily translate to safety. A total of 69 borrowers were downgraded in the first half of 2015, compared with 57 a year earlier, according to SWS Research Co., a unit of Shenwan Hongyuan Group Co. Companies in the metals and coal industries were the most affected amid reduced demand. Winsway Enterprises Holdings Ltd., an importer of coking coal that defaulted on its U.S. currency debt in May, said on Monday it has extended a standstill agreement pending discussions with bondholders and other parties.

“Investors should be cautious about low-graded companies,” said Bosera’s Guo. “Yields shouldn’t be the only thing to look at. We should still look at financial statements, and those doing well deserve low financing costs.”

The benchmark Shanghai Composite Index of stocks fell 14 percent in July, the biggest slide since August 2009. The gauge dropped 10 percent last week and 1.7 percent Wednesday.

Cheaper Money

China’s overnight repurchase rate dropped to a six-year low of 0.99 percent on May 29 after the PBOC reduced benchmark interest rates and cash reserve ratios for banks. The gauge of interbank funding availability climbed for a record 25th day to 1.49 percent Wednesday, the highest since May 5, a weighted average from the National Interbank Center shows.

Amid demand for carry trades, turnover of the contracts rose 18 percent last month from June, accounting for 90 percent of all pledged repo trades, up from 84 percent, according to Bloomberg calculations based on National Interbank Funding Center data.

The PBOC has been selling reverse repo agreements in open-market operations since late June, injecting a net 90 billion yuan into the banking system.

“The carry trade is based on assumption that liquidity will remain flush in the interbank market,” said Becky Liu, a rates strategist at Standard Chartered Plc in Hong Kong. “When there is a change of this expectation, the impact on the bond market will be amplified due to the leveraged positions.”

Targeted Control

China will step up targeted macro policy control to counter downward pressures on growth, the Xinhua News Agency reported July 30 following a Politburo meeting chaired by President Xi Jinping. The government will maintain a proactive fiscal policy and public spending, according to the report.

“As the economy continues to struggle, certain industries will face rising financial pressure,” said Frank Sun, a Shanghai-based bond analyst at CFETS-ICAP. “Still, bets on loose monetary policy needed to shore up growth will continue to benefit the bond market before equities stabilize.”

— With assistance by Helen Sun

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