Don't Panic: China's Deleveraging May Actually Be Good for Bonds

(Bloomberg) -- China’s deleveraging drive will benefit the nation’s bonds as it starts to weigh on the economy and prompts looser monetary policy, according to Fidelity International Ltd.

The campaign will cause a moderation in growth next year and, combined with less upward pressure on inflation, prompt the People’s Bank of China to adopt a neutral-to-easing bias, according to Bryan Collins, a fixed-income portfolio manager at Fidelity. The central bank currently follows what it calls a prudent and neutral policy.

A rally would be a sharp turnaround for the nation’s notes, which have slumped this year amid strong economic data. The deleveraging efforts have hurt the debt market so far because it has crimped the previous practice of using borrowed money to buy bonds. The benchmark 10-year yield spiked to the highest level since December 2014 on Tuesday, extending a slump after PBOC Governor Zhou Xiaochuan voiced concern about the high level of borrowing in the financial system. Still, Collins says a rally may eventually follow.

“I would expect to see a continuation of the current momentum to manage overall financial and corporate leverage," said Hong Kong-based Collins. "Such measures could help reduce government bond yields and help support credit spreads, both onshore and offshore."

The yield on China’s 10-year sovereign bonds climbed four basis points to 3.75 percent, bringing its advance so far this year to 69 basis points.

The decline in bonds came amid a sense of caution before the start of the 19th Communist Party Congress on Wednesday. The Shanghai Composite Index fell for a second day and the yuan retreated as much as 0.52 percent, the most since Sept. 28, as the dollar strengthened.

The twice-a-decade Congress tends to focus more on political changes rather than on providing minute details on financial policy. Investors will still look for indications on how far the deleveraging campaign will go. China has made initial progress in reducing borrowing and it has had no significant damping effect on the nation’s economy, Tuo Zhen, a spokesman for the Congress, said at a briefing.

Authorities are adopting both tight and loose policies to try to reduce the country’s dependency on debt without causing a hard landing, S&P Global Ratings analysts led by Christopher Lee wrote in an Oct. 16 note. The company cut China’s sovereign rating last month, saying it didn’t believe enough was being done to contain credit growth.