Any hopes that the international bond market in Asia might stabilise in June proved wide of the mark as primary and secondary market conditions both progressed from bad to worse during the month.
Ending the quarter on a sour note, the tough trading climate was described in stark terms by some in the market.
“This is a market that could completely shut down due to unstable pricing,” Jim Veneau, head of Asian fixed income at AXA IM, said. “Only the most resolute, the most focused, or the most desperate are accessing the market right now.”
That latter group includes China’s Local Government Financing Vehicles (LGFVs), which have $15.79 billion of international re-financing requirements through to the end 2019, according to HSBC’s calculations.
Their fall from grace has been remarkably swift with even the strongest LGFVs seeing their yield spreads widen by between 100 and 200 basis points over the course of June.
“The LGFV market is just not functioning right now," said one Chinese investment banker who could not be quoted for political reasons. "It’s not about whether the sector can re-finance upcoming dollar maturities, but how deep the re-pricing will be.”
At one end of the spectrum are lower-rated entities like BB- rated Qinghai Provincial Investment. It has seen its 7.875% March 2021 bond gap out from a yield of about 9.5% at the beginning of June to 21.45% by the end of the month.
At the other end, are A- rated entities like Tianjin Infrastructure Construction & Investment. It has a sizeable $108 billion balance sheet and comfortable 66.6% liabilities-to-assets ratio, according to S&P Capital IQ.
Yet its 2.75% June 2019 bond also widened from about 3.98% at the end of May to 5.216% at the end of June.
The spark was lit by another LGFV, Xilinhot Geipaishui, which officially defaulted on loans totalling Rmb4 billion ($603 million) at the end of May. Investors believe there could be a lot more defaults to come given the central government’s efforts to de-leverage the economy, particularly among the most poorly managed LGFVs.
CONFIDENCE DRAINING LIQUIDITY
But the government’s efforts to reassure financial markets that it wants an orderly rewinding have not yet had the desired effect.
On June 24, for example, the People’s Bank of China cut the required reserve ratio of banks by 50bp, provided banks use the money to fund debt-for-equity swaps or lend to small- and medium-sized companies adversely impacted by global trade tensions.
“You would have hoped that sentiment would have improved after this,” Veneau told FinanceAsia. “But unfortunately it didn’t happen and the currency weakened further instead.”
Over the past few weeks the renminbi has lost about 3% of its value against the dollar, pushing up foreign funding costs at a time when domestic borrowers have been forced onto offshore bond markets because the onshore one is all but shut.
However, China's National Development Reform Commission is closing this avenue down as well, refusing to issue quotas to Chinese property companies unless the proceeds are earmarked for re-financing. It is also said to be considering banning transactions with maturies of less than one-year, which currently evade its quota rules.
The net impact is likely to be fewer G3 bonds being issued in July than in June, which amounted to just $8.41 billion from China and $4.41 billion from Asia ex-China, according to Dealogic.
This should be welcome news for traditional fund managers since those borrowers that did access the market in June seemed to push overall spreads wider.
“There’s a negative feedback loop,” the Chinese investment banker commented. “Borrowers are only clearing the market if they pay a big enough premium over secondary market spreads. But what this is doing is to re-price the market to the next leg down.”
And there are fewer investors waiting in the wings to push it back up. China’s clampdown on the shadow banking sector has removed one big chunk of the onshore investor base, while offshore investors are sitting on growing cash piles in anticipation of redemptions.
However, Veneau argues that the indiscriminate nature of the re-pricing is throwing up opportunities. The key issue is when to grasp them.
“The upside is that once the market stabilises, we’ll have better entry levels and more attractive yields,” he explained.
“Good companies are being re-priced well below fair value ... So if we believe they won’t default, then the bonds that have re-priced well below par are going to deliver possibly 10 or more points in addition to coupon carry ahead of redemption,” Veneau said.
But Veneau said the hardest problem fund managers face right now is forming a clear view which way markets will go and then trading off the back of it. Volatility has become the norm and in June it intensified again after the US government announced its latest round of trade tariffs against China.
“It’s very hard to get conviction,” Veneau stated. “The market is also going through an adjustment and that just needs to work its way through the system.”
POSITIONING FOR THE UPSIDE
So how should fund managers respond? Veneau believes there is no point focusing solely on risk management since high levels of foreign exchange, interest rate and credit volatility make it almost impossible to work out what is likely to happen next.
Instead, he said AXA is trying to add value by adjusting its credit mix. One year ago it was all about barbell trades – sandwiching investment grade credits with more speculative ones to enhance a portfolio’s overall yield.
Now that crossover credits are offering up much higher yields, Veneau says it is better to focus more on the belly of the credit curve. Here higher BB-rated credits are offering 9% to 9.5% compared with 4.5% to 5% one year ago.
Both Veneau and the Chinese investment banker are hopeful the market will stabilise at some point during the third quarter, while acknowledging that the potential for escalating trade tensions poses the main tail risk.
The Chinese investment banker said he is advising borrowers in the pipeline to take a more active approach to how and when they approach the markets.
“We're telling them to forget about doing a roadshow,” he said. “The best approach is to watch the market every day and if there’s an opening to just jump into it before it disappears again.”