China’s local government financing vehicles, or LGFVs, were virtually unheard of among overseas investors four years ago. But they have rapidly become among the most prominent, and active, mainland issuers in the dollar bond market.
They raised $8bn in the dollar bond market last year, four times the amount they issued in 2014, according to Dealogic. Investors are hovering up their deals, attracted by implicit government support and strong ratings.
In the last week alone, Jinan West City Group joined the rush to the international bond markets, raising $300 million from its debut. That followed successful issues by Xi'an Municipal Infrastructure Construction Group, which raised $500 million, and Chongqing Western Modern Logistics, which built up a peak order book of $3.8 billion for its $500 million debut issue.
But not all investors are comfortable with this surge in supply. This is partly because of their wider fears about Chinese credits. Defaults or missed payments are rising in the onshore market. Many deals have been pulled as a result. But the real hot-button topic for investors is the issue of government support.
Some international investors admit they are unsure quite how far local governments will stand by LGFVs in the event of default. It is possible executives at these issuers themselves don’t know the answer. The problems at Bohai Steel — a company owned by the Tianjin government that is negotiating a restructuring plan with its creditors to deal with Rmb19.2 billion ($2.87 billion) debt — has only exacerbated these fears.
These questions have been asked for the last few years, but their urgency is growing. The reason for that is simple — supply from China’s LGFVs is about to explode.
Support network
In the early 1990s, local governments in China moved to set-up their own debt issuing vehicles. These governments were responsible for investing in local infrastructure, but their hands were tied by Chinese regulations. They were banned from issuing debt themselves and could not take loans from commercial banks. The creation of LGFVs seemed a sensible solution.
These vehicles gradually became frequent issuers in China’s domestic bond market. They now account for about a third of total non-financial corporate issuance onshore, according to data provider Wind. It was inevitable that they would eventually tap the dollar bond market.
The first LGFV to issue bonds offshore was Beijing Infrastructure Investment, which sold a $300 million five-year note in March 2014. But other issuers soon followed it to the market, and volumes blossomed.
These issuers are attracted by the cheap funding on offer, thanks to low dollar interest rates and a captive audience among international investors. The average three-year dollar bond from an LGFV pays around 3%, according to data from Wind. The average yield for the same maturity in the onshore market is 4.02%. In this context, it is little surprise the LGFV supply has boomed.
“China’s LGFV is a new sector that we cannot avoid,” said Angus Hui, a Hong Kong-based portfolio manager at Schroders.
But as issuance from the sector has risen, so have questions about quite how to value these deals.
Hui said the rise of LGFV issuance reminded him of the rush of dollar bonds from Chinese property companies over the last decade. These deals could generally rely on strong demand. But investors sometimes struggled to weigh up the risk and return, he said.
The usual assumption — and the easiest one — is that China’s provincial and central governments will stand by LGFV borrowers. Some bankers and investors point to the prolonged need for infrastructure investment in China as a reason these deals will not be allowed to fail. After all, that would cut off a key future source of funding for Chinese infrastructure.
“The default risk among LGFV is considered to be low given the projects undertaken are mainly government-related, hence the relatively high international rating granted,” said David Yim, Greater China DCM head at Standard Chartered.
Rating agencies certainly appear comfortable with the risks.
When Tianjai Binhai New Area Construction came to the market with an $800 million bond last year, it was given an A3 issuer rating by Moody’s and a Baa1 bond rating. That was a big jump from the stand-alone credit assessment of B2.
S&P, meanwhile, assigned a BBB+ rating on Chongqing Nan’an Urban Construction & Development’s US dollar notes. The rating agency said there is an almost certain likelihood that Chongqing Nan’an district government will provide support to the company in the event of financial distress.
But some market participants stress that the risks cannot be overlooked — and that some local governments may be less likely to support their LGFVs when things go wrong.
What’s the difference?
“We are not of the view that the government will bail out every LGFV,” said Ivy Thung, head of credit research at Nikko Asset Management.
It seems obvious that the chances of bail-outs will be different from province to province, and will depend a lot on the language used in the documentation. But at this point, investors seem to be taking a fairly blanket approach.
The buyers of the dollar-denominated LGFVs are predominantly Chinese investors with money offshore. They are often cash-rich and insensitive to aggressive pricing, bankers and investors said. But they are also prone to ignore differences in guarantee structures and local government credit strengths.
This is something that is likely to change, said Hui. It will be helped by the fact that the LGFV market is going to keep growing at a wild rate.
In a recent research note, HSBC analysts forecast that dollar denominated issuance from China’s LGFVs is likely to double to more than $20 billion in the next twelve months. Bankers tend to agree.
“For investors, there is a supply-side risk as there may be a large pipeline of LGFVs coming to the market,” said Sean Liu, head of debt capital markets at China Everbright Bank Hong Kong branch.
While there will certainly be some repeat issuers, bankers said most of this supply is going to come from new names. That could aid greater credit differentiation, but it may also increase the risk that things will go wrong.
The credit profile of recent issuers is already getting weaker, said a fund manager. This only exacerbates fears over local government support — fears that have been growing over the last year amid a rise in funding problems at Chinese state-linked issuers.
Bohai Steel, which was created in 2010 through the merger of four manufacturers, is seeking a government bailout to restructure its debt after failing to make a payment. China City Construction failed to make a coupon payment on time after a change of ownership. Neither of these issuers is an LGFV — but both came with implicit government support. That has made investors more cautious about quite how to value LGFVs.
Most bankers and investors think these problems are surmountable. The rampant growth in LGFV looks set to continue apace.
But investors are determined that as each new name is added to the market, they will be more careful about credit risks — and more demanding about yields.
