MNI China Money Week: Search for Yield Boosts Low-Rated Bonds

     BEIJING (MNI) - Chinese institutions' search for yield and looser liquidity

conditions in the interbank market over the last few weeks has driven a mini

rally in corporate bonds, especially in the less liquid AA- rated securities.

But as the central bank moves to tighten the money spigot again, the market is

wondering just how long the good times can last. 

     The yields on three-year AA rated corporate bonds fell by around 66 basis

points from 5.6031% on June 1 to 4.9401% on Aug 3. The spread between AA rated

corporate bonds and AAA rated corporate bonds narrowed by 35 basis points to 42

points, while the gap between AA rated bonds and Chinese government bonds (CGBs)

shrank by 55 basis points to 147 basis points, according to data from

chinabond.com 

     Long-term corporate bonds with low ratings have also outperformed CGBs and

corporate bonds with high ratings. The spread between 10-year AA rated corporate

bonds and 10-year AAA corporate bonds narrowed to 72 bps from 79 bps, while that

between 10-year AA rated bonds and CGB fell to 195 bps from 221 bps. 

     Bonds rated AA-, which are scarcer and more illiquid, have performed even

better. The credit spread between 3-year AA- rated corporate bonds and

three-year AAA rated corporate bonds went down 49 bps from 179 bps on June 1, to

130 bps on August 3.

     The main driving force behind the rally has been yield-hungry funds, whose

returns have been sliding or lagging behind what investors expected in the first

half of the year amid tighter regulation and liquidity conditions. The looser

liquidity that began in June has provided funds the opportunity to try and make

quick profits.

     "If you look at the first-half performance of funds investing purely in

bonds, the median and upper-quartile of annualized yields were 2.97% and 3.77%,

which are even lower than the yields on negotiable certificates of deposit

(NCDs)," Qin Han and Liu Yi, analysts at Guotai Junan Securities, wrote in a

recent report. "So when yields on corporate bonds look like they're going to

fall, funds that haven't been performing very well become very enthusiastic and

jump in, which pushes yields down even more."

     In June, funds increased their holdings of corporate bonds by CNY62.6

billion, compared with net sales of CNY167.5 billion in May, according to data

compiled by investment bank China International Capital Corp. (CICC). July data

is not yet available.

     "There's a huge pool of investors who buy CGBs -- big banks, small banks,

securities companies and so on, but the investor base that trades low-rated

corporate bonds is quite small, they are mainly in it to trade and make

short-term gains," a Beijing-based bond trader at a commercial bank told MNI.

"So they tend to act in a herd-like fashion -- when they see someone jumping in,

they pile in after them to buy low-rated corporate bonds, which really pushes

yields down quickly."

     CGBs are far less volatile than higher-yielding corporate bonds, so they

don't offer the same opportunity for opportunistic investors to turn a quick

profit. 

     Since July 1, the yield on the most-actively-traded 10-year CGB maturing on

May 4, 2027, has been trading in a narrow range of 3.55% to 3.64%, as the

People's Bank of China has managed liquidity to keep conditions within its

stated aim of "neither loose nor tight." The market has become fixated with

day-to-day liquidity conditions, watching the PBOC's open-market operations like

a hawk. 

     "The PBOC's management of short-term liquidity conditions has become the

focal point of the bond market," Tang Yue, an analyst at Industrial Securities,

wrote in a report this week. "Nine out of 10 bond traders and investors are

paying more attention to daily and weekly liquidity conditions than to medium-

and long-term economic conditions."

     The PBOC denied liquidity to the market on Monday this week, the last day

of the month, which usually is a peak time for cash demand. That led traders to

complain of very tight conditions and there was speculation in the market that

several financial institutions were unable to buy back their repos, some traders

told MNI. 

     The CFETS-ICAP money market sentiment index was at 66 at Monday's close,

the highest since May 2. But by Thursday it had fallen to 33, a sign that

conditions were improving, and the PBOC started to drain liquidity on Thursday

and Friday.

     "The market's still trying to come to a consensus on what this 'neither

loose nor tight' liquidity stance actually means and also how bad the

regulators' increased supervision is going to get," said the Beijing-based

trader. "We're in a bit of a wait-and-see phase, so yields on government bonds

are trading in a narrow range, treading water for now."  

     In this environment, buying up low-rated corporate bonds seems a risky but

rewarding option for investors who need to secure higher returns to improve

their ranking against their competitors. 

     "Based on our recent communications with investors, corporate bond yields

have dropped so much that they are afraid of being left behind if they don't

jump in,"  Guotai Junan Securities wrote in another report. "Even if their

hearts tell them to be cautious, they have to buy because of peer pressure and

performance pressure."

     A survey conducted by CICC on July 27 showed that nearly 60% of investors

said they believed the best way to boost returns in the bond market was to buy

low-rated corporate bonds issued by companies that were unlikely to default.

They also said that timing their purchases and sales was crucial, as was

increasing holdings of long-term bonds in their portfolio. The CICC analysts

said they were surprised by the responses, because they felt it was very

difficult for investors to find a few good apples in a bad bunch. 

     A correction in the corporate bond rally over the past week -- which saw

yields on three-year AA rated corporate bonds rise from 4.8544% last Tuesday to

4.9401% this Thursday -- has been taken by many analysts as a signal that the

mini bull-run is nearing its end. 

     "We think government bonds and policy-bank bonds have become more

attractive than corporate bonds," Qi Sheng, a fixed-income analyst at Zhongtai

Securities, said in a report on Monday. "There's been no let-up in the

regulatory environment and liquidity conditions remain tightly balanced with no

improvement, so the leveraging-up process will be limited.

     "On top of that, deleveraging in the real economy will lead investors to

demand a higher risk premium for corporate bonds. Economic conditions don't

warrant any further narrowing of credit spreads, so it's really not worth buying

corporate bonds right now." 

     Shenwan Hongyuan Securities analysts warned that against the background of

tight regulation, low-rated corporate bonds could be the first to suffer from

any unexpected shocks. "Investors are better off buying long-term corporate

bonds with higher ratings."

     This week, the benchmark seven-day deposit repo rate, which reflects the

cost of borrowing between banks rather than all institutions in the market,

remained relatively steady this week, declining from 2.8403% on Monday to

2.7819% on Thursday and was last trading at 2.7876%.

     The yuan strengthened against the U.S. dollar this week, rising by 0.37%,

the same as last week and the fourth weekly gain. It was last traded at 6.7198

on Friday, up from the close of 6.7429 last Friday.

--MNI Beijing Bureau; +86 10 85325998; email: he.wei@marketnews.com

--MNI Beijing Bureau; +44 203-586-2244; email: nerys.avery@marketnews.com

--MNI Beijing Bureau; +86 (10) 8532-5998; email: vince.morkri@marketnews.com

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