Short Sellers May Be Fueling China's Worst Bond Rout in Four Years

Updated on
  • Practice creates a vicious feedback loop: Huachuang Securities
  • Rise in bond borrowing shows more cash bond shorting, ANZ says
Bloomberg’s Emma O’Brien explains why short sellers are facing some of the blame for a bond selloff in China.

Short sellers may be aggravating China’s biggest bond selloff in four years.

While the nation’s debt market has no official measure of short sales, analysts say a surge in bond lending has been partially fueled by rising bearish bets. A record 1.82 trillion yuan ($274 billion) of notes has been lent out this year, 18 percent more than the total for all of last year, according to clearinghouse ChinaBond. Short sellers profit from falling bond values by selling borrowed notes and buying them back after prices fall.

"This creates a vicious feedback loop -- when institutions think bonds will fall, they borrow and sell, causing a plunge in the securities, which then drags futures down, and thus there’s more shorting," said Wang Wenhuan, an analyst at Huachuang Securities Co. in Shanghai. "As investors are still quite cautious, there will likely be more bond borrowing in the near term as yields climb."

The debt market has slumped under the strain of rising inflation and an official drive to curtail excessive borrowing, with the benchmark 10-year sovereign yield set for the biggest annual increase in four years. While Chinese regulators have a history of clamping down on bearish wagers in the stock and currency markets, they haven’t taken any major measures to curb short-selling of bonds.

The People’s Bank of China, which oversees the interbank bond market, didn’t reply to faxes seeking comment.

The nation’s government notes are headed for the worst selloff since 2013, with the 10-year yield surging 86 basis points this year to 3.92 percent. The rate dropped six basis points this week amid speculation recent losses were excessive.

Read more on China’s top bond fund forecasting that the rout may worsen

Market participants have borrowed 960 billion yuan of sovereign bonds and 710 billion yuan of policy bank notes this year. They like such securities for short selling and hedging because they’re the most liquid, said David Qu, a market economist at Australia & New Zealand Banking Group Ltd.

The amount of overall bond lending started picking up late last year, when policy makers began intensifying their deleveraging campaign. Financial institutions borrowed 170 billion yuan of notes every month on average in the past year, compared with 92 billion yuan in 2015, when the bond market was stronger.

Commercial banks may be borrowing securities to short, rather than selling government bond futures, because they aren’t allowed to trade the derivatives.

Seeking Liquidity

Still, not all bond borrowing is for shorting. It’s also used by traders seeking financing when cash supply is tight. For example, a financial institution could lend out its corporate bonds in exchange for more liquid government notes, then pledge them in the repo market for funding, according to Becky Liu, head of China macro strategy at Standard Chartered Plc.

Several recent cases suggest short sales may have exacerbated losses.

On Nov. 22, when the yield on China Development Bank’s 10-year debt surged to a high of 5.04 percent for the year, traders more than doubled their borrowing of policy bank bonds from the previous day. A similar jump in borrowing occurred amid a selloff of sovereign notes on Oct. 30.

"The increase in bond borrowing undoubtedly shows the market expects the yields to climb further," ANZ’s Qu said. "We still think the yields will rise, so against this background, the transaction volume of borrowing could continue to climb, accelerating the drop in bonds and even resulting in some overshooting."

— With assistance by Tian Chen, Xize Kang, and Robin Ganguly

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