China's bond rout triggers turmoil as leverage curbs bite

A Chinese flag flying near apartment buildings in Beijing.
A Chinese flag flying near apartment buildings in Beijing. PHOTO: AFP

HONG KONG (BLOOMBERG) - Leverage, counterparty risks and maturity mismatch. China's record bull run in bonds had all the signs of a bubble in the making.

Loose monetary conditions had fueled a sense of complacency, and all that was needed to trigger a reversal was for liquidity to tighten. When expectations for faster US rate increases added to pressure from rising funding costs in China, the correction in the debt market - which started in October - turned into a rout. Bond futures plunged by a record last week, the 10-year yield surged by the most in two years and interest-rate swaps reached a 20-month high.

The selloff has sparked a chain reaction among banks, funds and brokerages as losses spread. Much of the risk stems from a strategy favored by investment firms managing bank wealth products, which involves the borrowing of short-term funds to invest in debt. A year of low money-market rates made the trade lucrative, until the People's Bank of China started tightening funding in August in an attempt to trim excessive leverage in the financial system. Lenders began asking for their money back and cut off the supply of cash, forcing the investment firms to reduce their holdings and hedge losses with derivatives.

"These non-bank institutions have two problems," said Shi Lei, head of fixed-income research at Ping An Securities Co. in Beijing. "One is that they're being discriminated against in the funding market. Two, they are commissioned by banks and when banks want their money back, there will naturally be a stampede."

The rout has exposed the vulnerabilities of a market that had built a leverage chain entirely dependent on loose funding, bringing to mind last year's equity tumble, when investors cutting margin debt helped fuel a US$5 trillion crash. There is concern that some investors have been using offline agreements to entrust holdings to another firm to circumvent limits on leverage or investment scope, according to Ping An's Shi.

"The market turmoil we saw last week is no longer the result of liquidity crunch, but the result of a breakdown of trust," Tommy Xie, a Singapore-based economist at Oversea-Chinese Banking Corp, wrote in a note. "The collapse of bond prices finally exposed the counterparty risk. It may take some time to repair the trust."

With only about 10 per cent of 3 trillion yuan (S$625.09 billion) of wealth products managed by third parties having been redeemed by banks so far, the slide still has a way to go, said Shi.

The size of China's wealth-management products more than doubled in two years to a record 26.3 trillion yuan as of June 30 as savers sought returns higher than deposit rates. Of this amount, about 56 percent is invested in the bond and money markets, according to data from the China Banking Wealth Management Registration System.

With a boom in interbank and shadow-lending activities, banks' asset-to-deposit ratio rose to 1.5 at the end of the third quarter, near a record 1.51 reached at end-2014. So when interbank funding costs climbed, the lenders faced what analysts have termed a "liability famine," prompting them to sell their bond holdings.

The PBOC will include off-balance sheet WMPs in its framework for gauging risk to the financial system starting in the first quarter, a newspaper controlled by the central bank reported Monday. This will limit WMP expansion and worsen lenders' liability shortage, increasing liquidity risks and reducing demand for bonds, Ming Ming, head of fixed-income research at Citic Securities Co, wrote in a note.

The PBOC started tightening in August by selling 14-day reverse-repurchase agreements instead of seven-day ones, in a sign it wanted to curb the short-term funding on which traders relied for leverage. The authority then started pushing money-market rates higher, just as capital outflows were accelerating amid prospects of faster US tightening under Donald Trump's presidency.

Year-end complications have added to the mix, with funding conditions being typically tighter ahead of tax payments and a regulatory assessment of bank liquidity. The bond selloff resumed on Monday after stabilizing briefly in the previous session. The 10-year bond yield rose five basis points to 3.4 per cent, while the one-year yield surged 10 basis points to 3.1 per cent, a 20-month high.

Chinese leaders have pledged to rein in risk and emphasized a prudent and neutral monetary policy at an annual planning conference last week, spurring speculation they would tighten policy further. Yet the debt market correction is already starting to have knock-on effects on corporate funding, fueling concern defaults will climb. At least 66.9 billion yuan of bond sales have been canceled or postponed in December, compared with 29.7 billion yuan for all of November, according to data compiled by Bloomberg.

"If this situation continues, it will definitely hurt the real economy," said Kun Shan, Shanghai-based head of local market strategy in China at BNP Paribas. "It will hurt the corporate sector trying to get normal funding in the capital market."