China's Cash Rush Has the Bond Market Looking for the Catch

Updated on
  • Debt rallying as cash returns but analysts say it won’t last
  • PBOC is already draining liquidity as deleveraging continues

Dangers of China's Liquidity Rush

China’s bond investors are being given the chance to ratchet up leverage once again, but they may not want to.

Months of scarcity have given way to a mysterious rush of liquidity in China’s financial system, with money-market rates back near levels seen in April. The market has responded accordingly, with bonds rallying in the last two weeks of June. But what could be an invitation to plow back in to debt beaten down by Beijing’s leverage crackdown is being greeted warily by analysts.

Regulators aren’t done yet and the recent bullishness -- which saw the gap between AA and AAA rated Chinese corporate yields narrow to the least this year -- won’t be welcomed, says Ming Ming, head of fixed income research at Citic Securities Co. in Beijing. To Guotai Junan Securities Co. analyst Qin Han, the corporate bond rally is “crazy,” and will probably reverse.

“Investment opportunities in bonds are disappearing after these gains,” Qin said from Shanghai. “I’m bearish. Government bonds will likely drop, while the yield gap between AAA company- and lower-rated debt could widen beyond previous highs.”

Traders seem to have a watching brief on the situation. While liquidity is strong, the outlook is unpredictable, according to one trader who isn’t adding leverage at the moment. Another said the market was in wait-and-see mode, given there is no suggestion regulators are pulling back from their deleveraging measures. Both traders asked not to be identified as they aren’t authorized to speak to the media.

Read more about China’s efforts to reduce its leverage burden.

Wang Ming, chief operating officer at Shanghai Yaozhi Asset Management LLP, which oversees about 20 billion yuan ($2.9 billion) of fixed-income securities, is cautious about adding debt right now.

“There’s no change in policy direction, the authorities will continue with the deleveraging efforts and the central bank doesn’t seem likely to ease given the economic momentum,” he said. Even so, investing now may be a better idea than toward year-end, which typically brings “more uncertainty and usually tighter liquidity.”

Here are some reasons why analysts don’t recommend buying Chinese bonds at the moment:

The PBOC is draining cash

It appears the loose liquidity situation hasn’t escaped the authorities’ attention. The People’s Bank of China started draining more funds from the system toward the end of last month, withdrawing a net 750 billion yuan since June 21. This probably means the PBOC wants money-market rates to increase from current levels, said Becky Liu, head of China macro strategy at Standard Chartered Plc in Hong Kong.

Ten-year government bond yields -- which touched a seven-week low of 3.499 percent in June -- could climb to as high as 3.8 percent, she said. The rate increased two basis points to 3.6 percent on Friday.

NCDs are getting pricey

In China, smaller banks use proceeds from negotiable certificates of deposit -- short-term debt introduced in 2013 -- as a way to invest in the bond market. The cost of these certificates has been rising, with yields on three-month AA+ rated securities surging the most this year on Tuesday. The rate rose three basis points to 4.5 percent on Friday.

With the traditional mid-year cash crunch out of the way, Beijing may continue to tighten money-market rates, said Liu Dongliang, a senior analyst at China Merchants Bank Co. in Shenzhen.

“Investors shouldn’t be buying bonds with the hope of making a quick profit,” he said.

Central banks are turning hawkish

There are a number of “latent risks” in China’s bond market, not least that policy makers around the world are shifting toward tightening, said Guotai Junan’s Qin.

A sense of caution may be creeping in to the corporate bond market, with yields on one-year AA rated notes rising for three days after hitting a 10-week low on June 29. That saw the yield premium over higher-rated debt swell to 42 basis points on Tuesday, and it could return to 70 basis points -- this year’s peak -- as sentiment sours and investors dump lower-rated bonds, Qin said.

Read more about the potential impact of a hawkish shift on emerging markets.

“Other nations may boost interest rates and Chinese policy makers may resume tightening to reduce leverage,” he said. “Also, even though the economy is slowing, the situation isn’t bad enough to drive a major rally in bonds.”

— With assistance by Tian Chen, and Helen Sun

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