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Repeats Story Initially Transmitted at 08:01 GMT Dec 22/03:01 EST Dec 22
--'Supply-Side Reform' Fails to Have Intended Impact
BEIJING (MNI) - Three recent measures by China Development Bank (CDB) have
caused the yield curve on its own bonds to flatten and even invert, with yields
on 10-year CDB bonds lower than those of the seven-year bonds, but the bank's
effort to further bring down the 10-year yield may not be effective without
sufficient purchases by other banks and insurance companies.
Since mid-November, CDB has taken three measures -- in essence, its own
supply-side reform -- to bring down long-term bond yields, including issuing
swaps (See Dec. 1 "China Money Week: Heavyweight CDB Moves to Calm Market"),
suspending new 10-year bond issuance and giving "window guidance" to stop
investors from short-selling the most actively traded 10-year bond (Ticker
#170215), which will mature on Aug. 24, 2027. These measures were intended to
decrease the supply of 170215s, boosting its value and lower its yield.
Since November, CDB has carried out bond swaps -- buying back the oversold
170215s and issuing additional short-term CDB bonds -- three times, with the
latest done Dec. 7. CDB also suspended the issuance of 10-year bonds, also in
mid-November, and traders told MNI that CDB told some banks to stop lending the
170215s to short-sellers.
As a result, the yield on the 170215s decreased around 20 basis points to
4.7400% on Dec. 7 from 4.9350% on Nov. 22. It rebounded to 4.8300% on Thursday.
However, the short side now faces greater pressure. Two bonds issued in the last
two swaps, maturing on Jan. 23, 2018, and Mar. 3, 2019, saw their yields go up
from 3.70% and 4.40%, respectively, on Nov. 21, to 4.1200% and 4.6850% on Dec.
18, mainly caused by selling pressure that occurred after the bond swaps.
The CDB bond yield curve, as calculated by the China Foreign Exchange Trade
System, also showed that the yield spreads between one-year and 10-year CDB
bonds, and seven-year and 10-year CDB bonds, have narrowed from 53.8 and 5.7
basis points, respectively, on Nov. 22, to 24.3 and negative 9.8 basis points on
The situation is not ideal for CDB, as its recent bond swaps have actually
caused the whole yield curve to move up, except for the 10-year CDB yield, with
the costs to issue new CDB bonds increasing. In other words, CDB successfully
prevented the 10-year CDB bond yields from rising further -- whereas before they
had seemed destined to rise to 5% and beyond -- at the cost of shorter-term bond
yields going up.
CDB's inverted yield curve -- caused not by market forces but intervention
-- has two paths back to normality: either the 10-year CDB bond yields go up
with the whole yield curve, or the whole yield curve needs to move down. The
latter outcome is what CDB is shooting for, but that is not likely to happen.
CDB's supply-side reform effectively deterred short-sellers and had them
begin buying back the bonds, driving 10-year CDB yields down. But there is a
lack of interest by long-term investors in buying the 10-year bonds, meaning
what happened in October is likely to repeat.
The lesson from October -- when China government bonds and CDB bond yields
rose sharply -- is that short-term investors cannot drive down yields by much
without help from long-term investors (See Oct. 27 "China Money Week: Mood Dims
as 10-Yr CGB Yields Hit 3.8%).
--FEW BUYING SIGNS
Few signs indicate that long-term investors, including banks and insurance
companies, are willing to buy and hold a significant amount of bonds. The
statement at the end of the Central Economic Work Conference on Wednesday
stressed that the government will continue with financial deleveraging and that
the government's monetary policy stance will remain "prudent and neutral," so
the banks' ability to buy bonds may not significantly improve soon, as the
sluggish M2 growth suggests they may continue to suffer from lower deposit
If the purchasing power of the banks and insurance companies recovers, the
bond market will then naturally recover and push down the yield curve anyway,
regardless of whether CDB's supply-side reform succeeds.
A more likely outcome is that 10-year CDB bonds yields will rise, thereby
normalizing the yield curve.
Because many traders do not believe CDB's supply-side reform will work,
they are waiting for a chance to short sell 170215s, as they do not want to sell
too early and risk being squeezed by CDB and other 170215 holders.
However, if CDB begins to reissue its 10-year bonds or does not conduct
bond swaps for an extended period, this could be interpreted as a signal that
CDB has given up on restricting supplies of 170215s, and potential short-sellers
may then become active, with selling pressure limiting a further rise in 170215
This becomes a game between short-sellers and CDB. As CDB knows there are
short-sellers waiting, it will not give up its supply-side reform. However,
there is a limit to CDB's tolerance for suspending its issuance of 10-year
bonds, as that shortens the portfolio duration of outstanding CDB bonds.
As a result, CDB issued around CNY40 billion of 20-year bonds on Friday,
which was interpreted by the market as an effort to replace 10-year CDB bonds
and increase portfolio duration.
The bidding result barely met CDB's expectations. Bidding volume was only
1.32 times the issuance volume, with the primary yield at 5.14%, slightly lower
than the 5.15% level that the CDB can accept, traders told MNI. This might
suggest the game will continue for a while, as issuing 20-year bond remains an
option for CDB.
However, the demand for 20-year bonds is much lower than for 10-year bonds,
because the latter enjoys inherent liquidity advantages, which is especially
important during a bond bear market. Therefore, CDB will find it increasingly
difficult to issue 20-year bonds to replace the 10-year ones.
The only way for CDB to win this game is that it maintains its supply-side
reform until banks' demand for bonds recovers, which will lead to the downward
shift of the whole yield curve. Even a small-scale recovery may move CDB out of
the awkward position. However, if CDB cannot hang tough, it will be outplayed by
the market and the 10-year CDB yield will rise -- very likely above the critical
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