What risk? China investors snap up local government bonds as Beijing tackles big debts

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By Li Gu and Tom Westbrook

(Reuters) – Chinese investors are rushing to buy bonds of local government financing vehicles (LGFVs), including from the riskiest issuers, as Beijing’s fresh attempts to reduce local debt risks encourages them to bet on an implicit government guarantee.

    The scramble for yield has made LGFVs one of the rare popular investment targets in the wobbly Chinese economy, where stocks and property bonds have been slammed, and the yuan currency is weakening.  

    A slew of local governments – mostly debt-ridden ones such as Yunnan and Guizhou – have started selling so-called refinancing bonds this month in a special, one-time programme to replace other forms of borrowing.

    Such bond issuance, expected to hit 1 trillion yuan ($136.79 billion) by the end of this year, is widely believed to be part of Beijing’s measures to defuse debt risks of LGFVs – companies set up by local governments to fund infrastructure investment, a key growth driver for the world’s second-largest economy.

As the local governments raise fresh cash, investors expect LGFVs which have been constrained by the dire state of the property sector and economy will stay well funded.

    “The market is very excited about this new gift,” said Zhang Ziyao, founder and CEO of Shanghai Haisheng Fund Management Co, which is focused on LGFV investment.

    Haisheng, which manages 4.5 billion yuan of assets, has seen heavy money inflows in recent weeks as investors seek LGFV bonds, compressing credit spreads sharply.

    For some bonds issued by risky LGFV borrowers, “yields could come down 150 basis points (bps) in just one day … I have never seen such fever before,” Zhang said.

    Lower bond yields, which move inversely with prices, bode well for LGFVs which can borrow more cheaply. The credit spread of 1-year LGFV bonds rated ‘AA-‘ have shrunk 61 bps since August to the lowest level this year, data from ChinaBond shows.

LGFV bonds – estimated at around 13.5 trillion yuan – were battered earlier this year amid growing signs of fiscal stress, but have been back in favour since July, when China’s Politburo pledged measures to address local debt problems.

    Confidence rose further this month, as local governments started issuing refinancing bonds to repay outstanding debts. As of Monday, 17 municipal, provincial and regional governments had unveiled bond issuance plans exceeding 700 billion yuan.

Sources told Reuters this week the People’s Bank of China has ordered major state lenders to extend the tenor and reduce interest rates on outstanding LGFV loans.

    MAJOR THREAT

    LGFVs are financing vehicles set up by local governments to skirt Beijing’s caps on fiscal budgets and official borrowing.

    Thanks to the perceived government guarantee, LGFV debt, which includes loans, bonds, and shadow bank borrowing, has ballooned to roughly 60 trillion yuan, posing a threat to China’s financial stability.

    Huang Xuefeng, credit research director at Shanghai Anfang Private Fund Co, said proceeds from the refinancing bonds carrying coupons of roughly 3% will likely be used to replace LGFV debt with high interest rates – which exceed 10% in some cases. That will buy time for China’s most debt-laden localities such as southwestern Guangxi and eastern Shandong.    

    “Now that you have money on hand … you would certainly address the most pressing and urgent (debt) problems as a priority,” Huang said, adding his company has been increasing holdings of LGFV bonds in recent months.     

    Haisheng’s Zhang said that, unlike private property developers, LGFVs are state-owned and the central government will make sure their bonds won’t default.

    “You don’t look at LGFVs’ balance sheet. You look at policies,” Zhang said. “I think LGFV bonds are very safe now.”

    Yao Yu, founder of YY Rating, a Chinese credit research firm, agrees.

“LGFVs don’t rely on operational cash flows to repay debt… they rely on refinancing to roll over debt, whether through LGFV themselves or through the local governments.”

U.S. research firm Rhodium Group is among the sceptics, and reckons LGFV bond investors are “dancing on the edge of a blade.”

    “We don’t believe Beijing will take majority of local government debt onto its balance sheet so that everyone got guaranteed,” said Allen Feng, associate director at Rhodium Group.

    If an LGFV bond defaults and goes into restructuring, “we believe creditors will pay the bulk of the bill.” 

(This story has been corrected to say ‘southwestern’ Guangxi instead of ‘southeastern’ in paragraph 15)

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