China Faces Bond Market Test After Acting as Bastion in Rout

China’s $18 trillion bond market has proved remarkably stable in the face of rising yields around the world. A flood of issuance from the country’s local governments from April is about to put that resilience to the test.

Regional authorities are expected to expedite sales of new special local debt, just as short-term loans and corporate tax submissions are due. The brunt of the pressure -- with a record 7.1 trillion yuan ($1.1 trillion) of such debt expected this year according to official figures and data compiled by Bloomberg -- will fall on Chinese banks, asked to ensure growth while facing calls to cut leverage.

Foreign funds such as UBS Asset Management are underweight such debt, noting the looming supply, while others are counting on the People’s Bank of China to provide liquidity in the second quarter to help absorb the sales.

“Banks are under even greater pressure than last year to digest the bond issuance,” said Xing Zhaopeng, senior China strategist at Australia & New Zealand Banking Group Ltd. “The key issue here is that local governments lack funds, and the central government can’t let them be starved of it, therefore it can only let them roll the debt over.”

China Faces Bond Market Test After Acting as Bastion in Rout

Local government debt makes up more than one fifth of the nation’s bond market, and appetite for them is often an indicator of just how accommodating China’s policymakers are.

Average monthly net government bond issuance, led by local debt, could jump fourfold to 680 billion yuan between March and June, from 169 billion yuan in the first two months, according to Standard Chartered Plc analysts including Becky Liu.

The uncertainty over how local debt -- sold to fund everything from bridges to highways -- will be absorbed could spill over to the sovereign bond market. The 10-year benchmark yield could climb to 3.6% in the second quarter, ANZ’s Xing said. That would be a level unseen since October 2018.

So far, China’s sovereign bonds have escaped the global rout led by Treasuries. While yields on the 10-year U.S. benchmark have jumped 90 basis points since November to as high as 1.75%, the Chinese equivalent has fallen more than 10 basis points from a peak at that time to about 3.2%.

The resilience has been partly due to a record influx of foreign purchases, lured by the returns and inclusion of Chinese debt into major global indexes.

China Faces Bond Market Test After Acting as Bastion in Rout

But these bullish factors tend to favor the more liquid sovereign and policy bank bonds. That’s why investors had scrutinized Beijing’s recent decision to let regional authorities sell 3.65 trillion yuan of special debt -- which while less than last year’s record is more than expected.

In addition to that, local governments are slated to issue 820 billion yuan in general bonds this year to fund projected budget deficits, the Ministry of Finance’s annual budget report showed. They are also expected to sell another 2.67 trillion yuan of notes to refinance existing debt, according to data compiled by Bloomberg.

Overall, “net on net you’re going to see less but you’ll see more on the local government bond side,” said Hayden Briscoe, head of fixed income for Asia Pacific at UBS Asset Management in Hong Kong, whose fund is underweight Chinese local government bonds. “You should see it as a bullish sign for bonds this year, but bearish from a sector perspective on the supply in local governments versus sovereign.”

Liquidity Question

Banks are going to need the PBOC to pump money into the system -- probably through medium-term lending facilities, according to Citic Securities Co. and Guosheng Securities Co. The central bank has kept money market conditions generally balanced after engineering in January the worst cash crunch in more than five years.

Commercial lenders also will need to repay more than 1.6 trillion yuan of negotiable certificates of deposits -- short-term interbank borrowing instruments -- that will mature next month.

According to historical experience, if monthly net financing in China’s bond market exceeds 1 trillion yuan, it may significantly suppress investor sentiment, said Guannan Zhou, a fixed income analyst from Huachuang Securities. “This may be reflected in April.”

©2021 Bloomberg L.P.

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