Slim interest rates offered by banks in China over the last year have done a lot to marginalize small and medium-sized enterprises and have forced some of them to seek funding elsewhere. More importantly, however, was the lack of funding available to local governments in 2012 when the China Banking Regulatory Commission (CBRC) asked banks to limit the size of loans to local government financing vehicles (LGFV) and up risk control. Funding from banks was essentially capped and local governments struggled to fund ongoing projects, adding fuel to the China blow-up thesis.
As analysts at the Bank of America Merrill Lynch (BAML) highlight, the popularity of bonds and trust companies have exponentially grown over the last two years:
| “In 2012, net corporate bond financing increased 50%, while new trust financing surged to CNY1,025 billion from only CNY203 billion in 2011, a shocking 404% growth. Their combined share in total social financing almost doubled from only 12% in 2011 to 22%. The dramatic rise mainly took place in [the second half of the year], after the government rolled out a ‘proactive’ fiscal policy to put growth stabilization in a more important position. Local governments are the major beneficiary.” |
And local governments account for a weighty proportion of this:
| “The net issuance of the LGFV bonds surged 179% in 2012 and reached CNY1,132 billion, accounting for 50% of total net issuance of corporate bonds. In the trust market, assets of basic industries trusts expanded by CNY376 billion in [the first to the third quarters in] 2012, compared to only CNY21 billion expansion in 2011, and most of these trusts were LGFV related” |
But some of the worry is unfounded, says BAML as LGFV bonds are a lot safer than trusts.
Firstly:
| "Better credit quality of the issuer. The all-in costs for a trust issuer can be 10-17%. On the other hand, the yield of a 5 year LGFV bonds with the lowest credit rating A is only 9.5-10%. Most LGFV bonds are rated AA and above, which means the financing costs are only 4.8–6% for a 5 year bond, far below the cost of trust financing. As a result, an LGFV will choose bond financing as long as it is qualified to issue bonds. Typically, only the low-quality and those who cannot pass the criteria set by bond regulators choose trust financing. Because of the much higher costs, these LGFVs also run much higher credit risks." |
Secondly:
| "No imminent repayment pressure. The majority of LGV bonds have medium-to-long-term maturity, and the main redemption peak will come sometime in 2019. Repayment pressure before 2015 is very low. In the contrast, average duration of trust products is two years, so the repayment peak is estimated to be in the second quarter 2013 to the third quarter 2014." |
And last but not least:
| "Policymakers’ preference for bonds. In our view, policymakers have long encouraged the development of the bond market, but showed intent to limit the size of trust financing, which is an important component of shadow banking. This fits into their long-term objective of developing the capital market, improving the transparency of the local governments’ financing, and using the market force to rein-in their debt levels. As a result, the government will be much less tolerant of a default in bonds than trust products. The LGFV bonds’ backdrop is much stronger." |
So LGFV bonds, in the short to medium term, are attractive to buy-and-hold investors, says BAML.
In addition, underscoring the analysts' bullish view on the credit quality of local governments, in general, BAML even argues “a big sell-off following a trust credit event could be a great entry point".
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