October 27, 2015 / 9:07 PM / 4 years ago

High leverage shifts to China's bond market after equities deflate

SHANGHAI (Reuters) - Just when investor fears over plunging Chinese stocks appear to be calming down, the country’s frothy corporate bond market is stirring concerns it could be the next domino to fall.

An investor sits in front of an electronic board showing stock information at brokerage house in Fuyang, Anhui province, China, October 14, 2015. REUTERS/China Daily

Investment funds have flowed rapidly into corporate bonds since the stock market collapsed in June, triggering a surge of debt issuance. Demand has compressed corporate and sovereign bond spreads to their narrowest in four years - an oddity, when industrial profits are falling and credit risks are rising.

While bond investors say corporate bond prices are not at unreasonable levels, they are wary a sharp correction could be sparked by a bond default from major state-owned companies or a change in monetary policy.

“What concerns us is the narrowing credit spread between corporate bonds and government bonds, despite shrinking corporate profits,” said Zhou Hao, senior emerging markets economist at Commerzbank in Singapore. “In addition, we are also worried about the rising leverage ratio in bond positions.”

The People’s Bank of China has also weighed in with Vice Governor Yi Gang saying on Saturday the central bank is looking into leverage levels in the debt market.

China’s local governments and state-owned enterprises are burdened with worryingly high levels of debt. Sinosteel last week delayed interest payments to bondholders, deepening concerns about potential bond defaults.

Local media also have highlighted rising leverage in fixed-income structured products - an uncomfortable parallel with the margin-fueled equity meltdown this summer.

A vice president at a large fund in Hong Kong who deals with Chinese debt called onshore corporate debt expensive, but noted “tons of demand from mainland offshore institutions”.

LEVERAGE AND SUPPLY

Different factors appear to be driving the high leverage in China’s two bond markets - the bigger interbank market and the smaller exchange-traded corporate bond market - but analysts see the smaller of the two as more of a concern for fixed income investors.

Data suggests high trading volumes in the interbank bond repurchase (repo) market - the main venue for bond-backed borrowing - are linked to stock buying. Volumes jumped more than 60 percent in the second quarter but fell sharply in August as the equity bubble deflated. The recovery in equity markets in recent weeks has spurred a pick-up in interbank repo activity again.

The picture is muddier in the exchange bond market, where issuance is surging as companies take advantage of easier regulations and investors seek the relative safety of bonds.

Repo volumes on the Shanghai exchange rose 15 percent in the third quarter, up from a 10 percent rise in the second, even as the stock market corrected. Meanwhile, net corporate debt issuance hit a 17-month high of 327 billion yuan ($51.5 billion) in September, up nearly 70 percent from January.

Demand has been so strong that some firms such as property developer China Vanke (000002.SZ) sold a bond at 3.5 percent, 4 basis points below the yield of China Development Bank [CHDB.UL] bonds.

Investors say rising bond prices and rapidly rising supply pose mounting risks, but see no reason for alarm yet.

“To a certain extent this is a case of new supply driving demand, and there may be a limited lifespan,” said a bond fund manager at a buy side firm in Singapore. “But so far the new issuers are pretty credible.”

Still, given rich valuations, analysts caution that the financial system could be severely affected if a major state-owned enterprise fully defaults or a policy change causes renewed capital outflows. Goldman Sachs estimates China’s bond market - government and corporate debt - at about $4.24 trillion in 2014, the world’s third largest.

“If a big SOE really defaults, then it’s likely to reprice the onshore bond market which is trading very tight right now versus the offshore bond market,” said Annisa Lee, regional head of credit analysis at Nomura.

Additional reporting by Umesh Desai in HONG KONG; Editing by Jacqueline Wong

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