Debt issues back in focus as economy slows down

Local government bonds flourish as limited availability triggers demand from investors

The renewed focus by leaders at the national level on "stabilizing economic growth" has brought local government financing vehicles back from the brink of extinction.

Just weeks ago, many observers believed that such off-balance-sheet debt issues would soon be a thing of the past. Now, issues are expected to accelerate for the rest of this year, and even older LGFV securities are being snapped up by yield-hungry investors－even as a wave of on-balance-sheet municipal bonds starts to hit the market.

The prices of notes issued by LGFVs, created to sidestep a longstanding ban on direct debt issues by local governments, are rallying as these securities become scarcer in the market and the higher yields they offer become tougher to find.

The total return of a debt instrument is the price change plus the yield. Prices and yields move inversely in the secondary market.

As investors have become more confident in the security of LGFV debt repayments, they have become willing to pay higher prices for these securities. That factor has driven down the yields of the debt, but they are still higher than those for other comparable securities.

So far this year, the yield premium on three-year AA-ranked LGFV notes has narrowed by 37 basis points to 2.13 percent, according to Chinabond.com. The current yield on three-year sovereign debt is 2.86 percent, while the current yield on the AA-rated LGFV debt is 4.99 percent. Municipal bonds' average coupon rate, by comparison, is 3.17 percent for a three-year bond.

Yet LGFV debt has become scarce. As authorities clamped down on such borrowing last year, issues plunged to 80.35 billion yuan ($12.95 billion) in December, from a 266.9 billion yuan peak in April, according to financial data provider Wind Information Co Ltd.

The issue drought lasted into this year, with sale of new securities amounting to 498.9 billion yuan in the first five months, compared with 885 billion yuan the same period last year, according to Wind data. In February, the figure sank to a record low of 27.65 billion yuan, just one-quarter of the year-earlier total.

Investors were unnerved by a State Council document in October that banned LGFVs from raising debt on behalf of local governments. The cabinet's statement said that authorities have no obligation to repay debt that was not assumed for public works.

Regulators approved far fewer issues after that document, most of which were by entities that had previously obtained debt quotas before October. New project starts also plunged.

The scarcity saw the yield premium on three-year AA-rated notes widen by a record 89 basis points over the sovereign in December.

The fall in issue volume coincided with GDP growth falling to a six-year low of 7 percent during the first quarter. Concern that the economy might be in a free-fall prompted national policymakers to keep the investment engine humming.