{LONGTERMINVESTORS} China’s $1 Trillion Bond Leverage Unwinds as Pimco Senses Panic

 

China's $1 Trillion Bond Leverage Unwinds as Pimco Senses Panic
2016-04-28 03:39:02.438 GMT


By Bloomberg News
    (Bloomberg) -- China's bond traders are getting a painful
lesson on the dangers of leverage.
    After years of racking up profits by borrowing cheaply and
plowing the proceeds into higher-yielding debt, investors are
now rushing to unwind those wagers amid the deepest selloff in
13 months. The bets are getting squeezed from both sides as bond
prices sink and borrowing costs rise to one-year highs in the 8
trillion yuan ($1.2 trillion) market for repurchase agreements,
used by traders to amplify their buying power.
    While a reduction in leveraged wagers is arguably good for
China's long-term financial stability, it risks fueling a
downward spiral in a market that Pacific Investment Management
Co. says already shows signs of panic amid mounting default
concerns. The pullback challenges government efforts to revive
economic growth with cheap credit and could hardly come at a
worse time for Chinese companies on the hook for a record 547
billion yuan of maturing onshore notes in May.
    "It looks like everybody is cutting their leverage,
passively or pro-actively, as pessimistic sentiment continues to
brew," said Wang Ming, chief operating officer at Shanghai
Yaozhi Asset Management LLP, which oversees 15 billion yuan of
fixed-income securities. "Carry trades have become riskier."

                       Overnight Rates

    Outstanding positions in the repo market -- where investors
can pledge existing bond holdings for cash to invest in more
debt -- have dropped by 18 percent this year through March,
reversing a three-year climb to all-time highs in December.
While it's unclear how many of those transactions were used to
buy more bonds, analysts at Haitong Securities Co. and Minsheng
Securities Co. both say repos are the best available proxy for
leverage in China's debt market.
    It's getting more expensive for investors to lever up as
market volatility makes lenders more cautious and forecasters
push back estimates for another central bank interest-rate cut
to at least the fourth quarter. The cost of overnight repos has
averaged 1.99 percent this month, up from 1.14 percent in June.
    "There is still plenty of room for rates to go higher,"
Zhou Hao, an economist at Commerzbank AG, wrote in a report on
Wednesday.

                       Selling Pressure

    Investors are getting hit on the other side of the trade,
too, as bond prices slide. The Bank of America Merrill Lynch
China Broad Market Index of total returns on yuan-denominated
debt has declined 0.83 percent from a record high on April 4.
Government bonds have come under pressure as inflation increased
to the highest since mid-2014, while corporate notes are
slumping amid a spate of defaults and a surprise move by state-
owned China Railway Materials Co. to halt its bond trading this
month because of what the company called "repayment issues."
    "When you have a large SOE who suddenly suspends its bond
trading, you think: 'How many more are there?'" said Raja
Mukherji, the Hong Kong-based head of Asian credit research at
Pimco, which oversees about $1.5 trillion worldwide. "It kind of
leads to a bit of panic in the onshore market. Investors are
likely to want to look at their portfolio and sell some of the
bonds."

                        State Support

    While the losses may look small relative to the wild swings
in Chinese stocks last year, declines can be amplified in a bond
market where Haitong estimates leverage rose to a record 109.4
percent in February -- meaning investors use an average 100 yuan
of their own capital for every 109.4 yuan of bonds they
purchase. Traders who bought near the peak of the market had
little room for error: The yield difference between five-year
sovereign notes and the overnight repo rate fell to a one-year
low of 38 basis points on March 31.
    "We have started to cut bond holdings, shorten duration and
lower leverage from the first quarter," said Cheng Peng, the
Beijing-based head of investments at Genial Flow Asset
Management Co., which oversees about 20 billion yuan. "We will
be more cautious."
    A deep downturn in China's bond market is unlikely because
regulators would step in to prevent losses from getting out of
hand, according to Wei Zhen, a money manager at Bosera Asset
Management Co. in Shenzhen.
    "We don't think there will be a big correction in the
corporate bond market unless continuous and large-scale defaults
trigger a liquidity crisis in the financial system," Wei said.
"The probability of such systemic risks is very low given
regulators' good care for the market."
    Authorities have already signaled concern over the buildup
in leverage. China Securities Depository and Clearing Corp.
surveyed some brokerages on the use of borrowed money in the
exchange-traded bond market, people familiar with the matter
said in December. Regulators also sent questionnaires to fund-
management companies to seek information on their outstanding
repo positions, the Securities Times reported on March 28,
without citing anyone.
    China's experience with the stock market shows how
difficult it can be to contain a reversal in leveraged bets.
Domestic shares lost more than $5 trillion of value last summer
after regulatory curbs helped cut outstanding margin debt in
half.
    A prolonged selloff in bond markets would have even greater
impact on economic growth than the tumble in stocks. Net
issuance of corporate debt swelled to 1.24 trillion yuan in the
first quarter, or 19 percent of total financing. That compares
with 284 billion yuan of equity issuance by non-financial
companies, central bank data show.
    As defaults spread and China's central bank refrains from
cutting interest rates, there could be more trouble ahead for
bond investors, according to Sun Binbin, an analyst at China
Merchants Securities Co.
    "The volatility in funding costs, coupled with exposing
credit risks, are draining the liquidity in the bond market,"
Sun said. "Given the market expectation of a neutral monetary
policy stance, investors may continue to be forced to de-
leverage."

--With assistance from Molly Wei, Lianting Tu, Charlie Zhu and
Sandy Hendry. 

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