Photographer: Xaume Olleros/Bloomberg

China Financing Vehicles Find Dollar Bond Buyers as Yuan Slides

  • LGFVs sell $3 billion of global bonds as capital flees yuan
  • Funds ‘start to worry about LGFV default risk:’ HuaAn Asset

Chinese local-government financing vehicles have reacted to a 55 percent drop in their domestic bond sales this quarter by turning to the global dollar debt market, where onshore investors are seeking haven from a weakening yuan.

LGFVs have sold $3 billion of U.S. currency notes in the offshore market, compared with $200 million in the first three months and $2.4 billion in the same period of 2015, data compiled by Bloomberg show. Their domestic bond sales slid to 116 billion yuan ($17.4 billion) since March 31, down from 256.4 billion yuan in the year-earlier quarter, as surging defaults pushed up funding costs. The yuan weakened 2.3 percent against the dollar this year, partly as Chinese investors diversified into other currencies.

Builders of sewage works, bridges and subways in China’s regions still have 3.7 trillion yuan of onshore bonds outstanding, larger than the output of Poland’s economy, even after regulators allowed the exchange of LGFV debt into newly permitted municipal notes.
HuaAn Asset Management (Hong Kong) Ltd. recommends taking time to pick issuers with good fundamentals because supply of the debt will rise in offshore markets and central government support can’t always be relied on.

“I wouldn’t hurry to buy many LGFV bonds now because more will be sold,” said Terence Cheng, chief investment officer at the fund company. “Onshore investors start to worry about LGFV default risk. LGFV dollar bonds’ relative value isn’t ideal because their ratings are too high.”

For a look at the variety of excuses in China for bond defaults, click here.

Offshore rating companies may have factored in too much state support, so the number of downgrades on LGFVs may exceed upgrades in the coming years, Cheng said.

Borrowing by regional authorities surged after the 2008 global financial crisis, when the government urged provinces to boost infrastructure spending. They set up thousands of LGFVs for specific projects since they were at the time banned from selling bonds directly. Total borrowing by 29 of China’s provinces surged to 16.2 trillion yuan at the end of last year, up 53 percent from 2013, according to a March 22 Bloomberg Intelligence report.

Provincial risks based on fundamental factors (Source: Bloomberg Intelligence)

LGFVs’ bonds have met strong demand overseas. Wuxi Construction & Development Investment Co. got more than $1.2 billion in orders for its sale of $300 million bonds on June 21, according to a person familiar with the matter, who asked not to be identified. In contrast, Chinese financial company Zhongrong International’s $500 million bond sale got only $600 million of bids this month, according to another person familiar.

Tianjin Infrastructure Construction & Investment Group Co. sold $500 million three-year notes earlier this month. Xuzhou Economic Technology Development Zone International Investment Co. issued a $300 million of three-year debenture in June. Yunnan Metropolitan Construction Investment Group Co. is meeting investors for a potential bond offer offshore.

Yuan depreciation has attracted more capital from mainland Chinese investors into offshore dollar bonds. The amount of assets managed by Chinese overseas fixed-income funds through the qualified domestic institutional investor scheme almost doubled to 7.94 billion yuan as of March 31, from 3.898 billion yuan at the end of last year, according to data compiled by Shanghai-based research firm Z-Ben Advisors.

The average coupon rate of three-year dollar-denominated debt issued by Chinese LGFVs this month was 3.2 percent, compared with 4.02 percent on yuan notes in the domestic market.

Currency Gains

“LGFVs’ dollar bonds are mainly picked up by Chinese investors who want to gain from currency movements,” said Ivan Chung,  head of Greater China credit research at Moody’s Investors Service in Hong Kong. “For Chinese investors, in addition to yield, they expect some gains in currency as the dollar strengthens.”

Yield premium of onshore five-year AA rated LGFV bonds over similar-maturity government notes has widened 11 basis points this quarter to 136 basis points, set for its first quarterly increase since 2014, according to Chinabond data.

Chung said buyers of the bonds should assess the issuers’ balance sheets and backers. China local governments’ contingent debt was about 7 trillion yuan, Ministry of Finance official Wang Kebing said on June 23, without elaborating on LGFV borrowings. Rapid deleveraging of China’s debt can bring new risks and should be done gradually, National Development and Reform Commission official Sun Xuegong said at the same briefing.

“The key risk for investors is LGFVs typically have bad weak fundamentals and they rely on local governments for implicit support, which does not equal a guarantee,” said Moody’s Chung. “Policy support may change overtime.”

— With assistance by Lianting Tu, and Judy Chen

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