Templeton Shuns Corporates as Yield Spread Narrows

Chinese corporate bond yields the lowest in four months above the government’s, prompting a joint venture of Franklin Templeton Investment to avoid the debt.

“The credit spread may widen in the second quarter,” said Diao Huiyu, head of fixed-income investment in Shanghai at Franklin Templeton Sealand Fund Management Co., which oversees about 17 billion yuan ($2.7 billion). “The outlook for China’s economy still isn’t clear. I am a bit worried about the sharp decline in the gap between government and corporate bond yields.”

The extra yield investors demand to hold 10-year notes sold by top-rated companies instead of sovereign debt shrank to 157 basis points on March 18, the least since Nov. 6, Chinabond indexes show. In the U.S., similar-maturity notes from top-rated corporate issuers yield 40 basis points more than Treasuries, according to data compiled by Bloomberg.

China’s new Premier Li Keqiang said this month he will focus on opening the economy to market forces and stripping power from the government in a “self-imposed revolution,” setting a 7.5 percent economic growth target through 2020 that is slower than the 9.4 percent average in the past 10 years.

Disappointing February data prompted Bank of America Merrill Lynch to lower its 2013 growth forecast to 8 percent from 8.1 percent on March 20. Industrial production rose 9.9 percent in the first two months of 2013, the weakest start to a year since 2009, while retail sales missed economists’ predictions to grow 12.3 percent. New local-currency loans fell to 620 billion yuan in February from 1.07 trillion yuan in January, the People’s Bank of China said.

Debt Costs

Many lenders have started to control the scale of loans for real-estate development, the China Securities Journal reported yesterday. The China Banking Regulatory Commission is drafting guidelines on property lending, the newspaper cited an unidentified person close to the regulator saying.

The yield on AAA-rated 10-year corporate bonds dropped 11 basis points this year to 5.18 percent yesterday, according to Chinabond, the nation’s biggest debt clearing house. That on similar-maturity government debt was unchanged at 3.57 percent.

The cost of insuring China’s debt against non-payment has risen three basis points this year to 69 yesterday, the highest since Feb. 5, according to data provider CMA, which is owned by McGraw-Hill Cos. and compiles prices quoted by dealers in the privately negotiated market.

Credit Risks

The new government will “probably focus on stability in economic policy, and it’s not necessary for them to seek a robust recovery,” said Franklin Templeton Sealand's Diao. He said he is cutting holdings of bonds rated AA or lower as worries about the economy will have a bigger impact on lower -rated bonds.

The yield on three-year AA medium-term notes has jumped 15 basis points to 5.11 percent this month, widening the spread over similar AAA securities to 57 basis points, the highest since Jan. 16.

“We expect more credit events to surface this year, which will force the market to re-evaluate the credit risks,” Bank of America Merrill Lynch Hong Kong-based analysts Ethan Mou and Bin Gao wrote in a March 25 note. The failure of local authorities to prevent a March 18 convertible-note default by solar-panel maker Suntech Power Holdings Co. was “an important signal of the changing attitude of the government,” they said.

Government Backing

Government-backed companies such as Hebei Iron & Steel Co. would also stand to lose from any reduced state support. The yield on November 2016 bonds in China’s fourth-largest steelmaker was 4.82 percent on March 26, compared with the 5.09 percent coupon offered at its 2011 sale, according to China interbank prices.

The gap between corporate and government yields may see a “small” increase in the second quarter as inflows of speculative capital wane, said Chen Jianheng, a bond analyst in Beijing at China International Capital Corp., the country’s biggest investment bank.

“Since the end of last year, there has been some hot money flowing into China because of the optimistic sentiment about China’s recovery,” said Chen. “However, data in the first two months shows growth momentum in the economy isn’t as strong as expected, so the inflows will probably decline.”

‘Buying Opportunities’

Diao’s Franklin Eternal Credit Bond Fund has handed investors a return of 1.9 percent so far this year, according to data compiled by Bloomberg. The fund’s two biggest holdings at the end of the fourth quarter were Xugong Group Construction Machinery Co.’s 5.09 percent note due in November 2016 and Shangyu Communications Investment Corp.’s 6.7 percent bond due in September 2019, according to its quarterly report.

While credit spreads will widen, Diao said, the correction will give investors the chance to buy corporate bonds because inflation will remain controlled this year.

“Inflation won’t be a big concern in the coming two to three months,” he said. “Even though it may accelerate in the third and fourth quarters, it probably won’t rise above the market’s expectation. So any rise in corporate bond yields won’t be big and will actually present buying opportunities.”

Yuan positions at local lenders accumulated from sales of foreign exchange to the central bank, an indication of cross-border capital flows into China, rose to a record 684 billion yuan in January, official data showed on March 5. The yuan was unchanged at 6.2110 per dollar yesterday.

Consumer Prices

The seven-day repurchase rate, a gauge of interbank funding availability, has averaged 3.17 percent so far this quarter, the lowest since 2010, according to the National Interbank Funding Center. It jumped 12 basis points yesterday to 3.10 percent on concern over monetary tightening.

Consumer prices climbed 3.2 percent in February from a year earlier, the highest in 10 months, from 2 percent in January, the statistics bureau said on March 9. Inflation may slow to 2 percent again in March, the central bank’s academic adviser Song Guoqing was cited as saying by the Shanghai Securities News yesterday. The government set a target of 3.5 percent this year, compared with 4 percent in 2012.

“The credit spread will widen because the economy is showing signs of a slowdown,” said Shi Lei, head of fixed-income research at Ping An Securities Co., a unit of China’s second-biggest insurance company. “But the slowdown is temporary,” he said, adding that “the widening of the credit spread will probably last about three months.”

Shi forecast the economy will expand 8.2 percent in the second quarter and grow as slowly as 7.8 percent in the first three months of this year.

— With assistance by Judy Chen

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