Amid the current wave of enthusiasm for offshore bonds from Chinese local government financing vehicles (LGFVs), investors should exercise caution when choosing where to invest. The sector is a minefield of credit risk.
The issuance of LGFV US dollar bonds this year has already outstripped that of the last couple of years. So far, bond sales have surpassed $6 billion, which is more than the $4.8 billion for the whole of last year and the $2.2 billion for the year before, according to Bloomberg data.
The substantial increase of LGFV offshore issuance in 2018 and 2019 means that avoiding the sector altogether can result in underperformance. But there is the risk that the renminbi may weaken in response to US trade tariffs. And that will increase the burden on borrowers, according to Peter Sengelmann, chief investment officer of US investment management and financial planning firm Thun Financial. “I would approach the sector with caution,” he said.
A Barclays report at the end of April expects the supply of offshore LGFVs bonds to pick up in the coming months, because offshore yields have been falling while LGFVs have offshore maturities to refinance.
An S&P Global Ratings report from January reckons we are likely to see US$10 billion LGFV issuance this year - one-third of outstanding issuance in the sector.
LGFV US dollar bonds continue to pile into the market. For instance, Yiwu State-owned Capital Operation has just sold a Regulation S $600 million bond 3-year bond, with a reoffer price of 99.723 and coupon of 4.5% to yield 4.6%.
An indicator of hot investor demand for LGFV paper was seen in the $400 million 5.7% 3-year bullet issued by Zhuzhou City Construction Development, which was four times oversubscribed. Fitch Ratings has rated the bond BBB-.
“The level of international investor interest in investment grade LGFV offshore bonds has recovered materially since the middle of last year and has been stronger this year given the inflows and liquidity,” said Ken Wei Wong, Asia Pacific head of fixed income syndicate at Barclays.
But for financially weaker LGFVs with lower credit ratings, there is no guarantee for how long they can keep successfully raising funds internationally. The supply of investment grade LGFV offshore bonds is limited so far, “so the demand for these bonds will stay strong for the foreseeable future,” Wong said.
International investors have become more discerning on LGFV offshore bonds. “They will pick the names they like,” said Avinash Thakur, Asia Pacific head of debt origination at Barclays.
DEFAULT RISKS
Making the wrong choice can be dangerous. For example, aluminium producer Qinghai Provincial Investment Group (QPIG) failed to pay the coupon on its $300 7.25% 2020s at the end of February. Over the next few days, the LGFV did settle its overdue bond payments and narrowly avoided default.
QPIG's missed payment shows that not all Chinese government-related entities (GREs) can rely on state support. Fitch expects support for large GREs that serve important policy functions, but said that support is less likely for smaller GREs that operate in highly commercial activities.
“It is also in line with our view that the Chinese government's efforts to reduce guarantees and improve market discipline are increasing default risks for GREs,” the ratings agency said at the end of February.
US economic consultancy Rhodium Group agrees that LGFVs are facing growing risks of default, despite the Chinese government’s measures last year to permit debt renegotiations and extensions. In the first quarter, 78.7% of LGFV bonds were used to repay or refinance maturing debt or to swap for other debt instruments, up from 19.3% in 2013, it pointed out.
High refinancing needs exacerbates default risks. Almost two-thirds of China’s provinces are using over 75% of the proceeds from LGFV bonds to refinance existing debt. It is unsurprising that those that default are top in terms of the ratio of LGFV bond proceeds used for repayment. In Qinghai, QPIG's home province, the proceeds from all new LGFV bonds were used to refinance old debt.
To prevent default, the Chinese government has introduced new measures to refinance and restructure debt at lower interest rates, but it isn't working. “So far the primary policy instruments - bond swaps and policy bank loans - have been underwhelming, and as a result, more defaults should be expected in 2019,” Rhodium said.
Credit risk will be concentrated in Chinese provinces and cities that are suffering from slower credit growth and rely disproportionately on quasi-fiscal spending to support growth.
“The fundamentals and the financial conditions of LGFVs are currently deteriorating and defaults among many types of liabilities are starting to pile up,” the US economic consultancy warned.
But pricing of LGFV debt is more sensitive to Chinese government policy than LGFVs’ operating performance. Over the past months, the signals of a policy shift from regulatory tightening to monetary easing and fiscal support for the economy have drawn LGFV bond investors back to the market, which is why LGFVs have enjoyed greater access to cheaper bond financing.
Only the best LGFVs will issue offshore bonds, since there is bigger reputational risk for China if an offshore bond defaults.
