China's Leverage Campaign Is Turning Bond Market Upside Down

Updated on
  • Liquid market has become paramount consideration, trader says
  • Curve likely to stay flat on long-term policy focus: Citic

Impact of China's Deleveraging Efforts

China’s anti-leverage campaign is causing a distortion that hasn’t happened in the nation’s $9 trillion bond market in at least a decade.

The five-year sovereign yield is now higher than that on debt due in a decade, the first time the curve has inverted for the tenor in data going back to 2006. This is due mainly to a surge in the shorter-term yield because of a deleveraging campaign, and a limited advance in the 10-year cost as economic growth concerns raise demand for safety.

Mark Mobius, chairman of Franklin Resources, says Chinese companies are at risk without state backing.

Source: Bloomberg

The inversion illustrates the risk of China’s campaign to reduce leverage in the financial system, with higher borrowing costs influencing the corporate bond market and driving up rates for companies looking to refinance short-term debt. The nation’s nascent economic recovery is being pressured as well, with initial indicators including that on manufacturing suggesting that activity is slowing.

“It’s hard to say where the funding costs will be able to stabilize, so that’s curbing demand for the short-end of the curve,” said Wu Sijie, a Shanghai-based senior trader at China Merchants Bank Co. “A liquid market has become the paramount consideration, as people want to escape as fast as they can in a selloff.”

The monthly average net financing by corporate bond sales was a negative 26 billion yuan ($3.8 billion) in the first four months of this year, which means that the amount of maturing notes exceeded issuance. Companies have canceled about 318 billion yuan of bond sales this year. That’s a challenge for an economy that has some 5.3 trillion yuan of corporate debt coming due in 2017.

Regulators are beginning to notice.

With the deleveraging campaign erasing around $500 billion from local stocks and debt, the central bank boosted cash injections this week and provided more seven-day funds, the cheapest form of financing it offers. A quarterly People’s Bank of China report issued late Friday signaled that officials see little need to drive interbank rates any higher.

The apparent softening is coming after months of intensifying tightening that drove the overnight repurchase rate 66 basis points higher this year to 2.76 percent. The yield on one-year government bonds jumped more than 80 basis points to 3.48 percent. That helped reduce trading of overnight pledged repurchase agreements -- a rough gauge of leveraged trade -- by 34 percent to 34.6 trillion yuan in April, compared with a record 52.3 trillion yuan in August. The 10-year sovereign bond yield was last at 3.61 percent and the five-year at 3.65, leaving a gap of four basis points.

Tight Reins

Still, analysts say that the PBOC is unlikely to let go of the reins anytime soon, and that the drive to cut risk in the financial system is here to stay. This presents a buying opportunity for longer-term debt, according to Citic Securities Co.

“The curve is likely to stay flat because deleveraging is a long-term policy focus, and it will help discourage investors borrowing short-term money to finance investments in long-term bonds,” said Ming Ming, Beijing-based head of fixed-income research at Citic. “We like government bonds at the long-end of the curve -- the 10-year yield has probably peaked for the near term as economic data are starting to indicate downside pressure for growth.”

— With assistance by Helen Sun, Jing Zhao, Emma Dai, Yuling Yang, and Kyoungwha Kim

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