Asia ex-Japan corporate bonds had a spectacular year with issuance volume totalling $739.71bn by early December, a rise of 28% over 2015, according to Dealogic data. One sector shone in particular with deals from Chinese local government financing vehicles reaching a new high.
The asset class is still fairly new. The first LGFV bond was printed by Beijing Infrastructure Investment in June 2014. Since then, close to 40 names have ventured out to the offshore bond market, mostly issuing in sizes of between $200m and $500m.
And it was 2016 that really saw the asset class take off. LGFVs accounted for approximately $10.82bn worth of bonds this year, Nomura estimates. By contrast, issuance volume reached $3.10bn in 2015 and $1.52bn in 2014.
The surge in issuance was driven by number of developments that demonstrate a maturing of the asset class. First of all, deals were no longer limited to investment grade names.
Jiangsu NewHeadLine’s double-B rated $200m 6.2% three year from January was the first high yield transaction from a Chinese LGFV. Since then a parade of high yield names have ventured out including Xuzhou Economic and Technology Development Zone State-Owned Assets Management (BB+), Jiangsu Hanrui Investment Holdings (BB+) and Jiangsu Fang Yang Group (BB).
One reason for the emergence of high yield names and the uptick in LGFV debt is the strong support it receives from onshore China. Thanks to their familiarity with local governments and their LGFVs, banks and asset managers with a Chinese background feel more comfortable purchasing those notes. High yield names in particular leverage off such onshore support.
Also for the first time, issuers from provinces and municipal cities in the central to western part of the country also started tapping the bond market. Borrowers from Chongqing, Gansu, Shanxi and Yunnan made debuts this year. Previously, the pipeline was mainly concentrated in higher tier local governments in the coastal areas China likes Jiangsu, as well as the political and financial hubs of Beijing and Shanghai.
Terry Gao, director of international public finance at Fitch Ratings, believes one reason behind the geographic shift of issuers to “the so-called economic development zones” is because lower-tier cities are facing higher onshore funding costs than higher-tier ones like Beijing and Shanghai.
The attractive pricing level achieved by some LGFVs also encourages others to look at raising funds via this channel, according to David Yim, head of Greater China DCM at Standard Chartered.
“In some cases, some of these LGFVs are actually encouraged by the local government to tap the offshore market. It’s a kind of publicity, to promote that particular city or province. There are cases where one from a particular city or province issues and others follow because they don’t want to be left behind,” Yim said.
Such encouragement was reflected by the fact that LGFVs from the same provinces or municipal cities often tapped the market within months of each other in 2016. For example, Yunnan Provincial Investment Holdings Group and Yunnan Provincial Energy Investment Group printed their respective dollar bonds at the end of March and in late April, followed by Yunnan Metropolitan Construction Investment Co which sold its $500m 3.125% 2019s on July 5.
Chongqing Nan’an Urban Construction and Development and Chongqing Western Modern Logistics Industry Zone Development Construction sealed their respective transactions only 1.5 months apart.
Pick and choose
What keeps investors interested in the sector is the government linkage and the attractive yield that comes with it.
“China is such a big country, and besides investing in SOEs, before looking at purely privately-owned enterprises, a natural next level of credits to consider would be LFGV deals which still retain a linkage to the government on a provincial or city level and yet provide a higher yield,” said Clifford Lee, head of fixed income at DBS.
However, as supply boomed, investors became choosier over which credits they were willing to buy into. More than the industry in which the LGFV operates, key is the level of government backing, as well as the strategic importance of the LGFV.
Peng Jie, credit analyst at Western Asset Management Company, admitted that her firm is open to this type of credit, given its growing presence in the Asian market, “but we have been very selective”.
“For example, in general, we would prefer LGFVs carrying high policy roles such as those involved in public transportation and utility services provision, and less prefer LGFVs in vanilla infrastructure construction such as primary land development.”
For example, Metro operators Beijing Infrastructure investment, Tianjin Rail Transit Group and Guangzhou Metro Group appealed to Peng’s firm, and also a more recent offering from Xi'an Municipal Infrastructure Construction Investment Group Corp.
Not only is it from Xi’an, the capital city of the Shaanxi province, said Peng, this entity also plays a very critical role in the local economy and the public welfare, because it’s the primary platform to conduct gas and heat supply, and public transportation for the local government.
The growing selectiveness is reflected in this year’s smaller order books. Books have been around 2x covered for investment grade names, while for high yield they have been even smaller on occasion, noted Frank Kwong, head of primary markets, Asia Pacific global markets at BNP Paribas. To him, this is a clear sign that investors are a lot more selective, given the amount of supply.
Although the demand from China is still the main driving force behind LGFV debt, the investor base for these deals is developing and diversifying at the same time.
“We are seeing more international fund managers going into the transactions. On the IG side, we’ve also seen participation from sovereign wealth funds,” said BNPP’s Kwong.
“Foreign investors are highly concerned over the jurisdiction where the local government is, how strong its linkage with the central government is, and the importance of that jurisdiction to the central government,” Kwong said, adding that certain types of infrastructure projects that are being refinanced – like rail and sub metros – will see stronger demand from investors than some others.
While dynamics between onshore and offshore funding cost is certainly one main reason behind LGFVs’ growing presence in the offshore bond market, StanChart’s Yim says the debt raised offshore is also about finding new sources of capital.
“Sometimes it’s not about comparing costs – it’s about exploring another funding channel, which in this case is the offshore market,” he said, adding that moving proceeds from offshore to onshore China is easier than before. “One to two years ago, the central government is more concerned about funds coming into China, whereas now they are more concerned about funds flowing out, and might actually encourage offshore funding.”
To DBS’s Lee, however, issuing offshore is a response to their natural dollar funding needs. “The gap between onshore and offshore USD funding costs, on an after-swap basis, is narrowing and onshore liquidity has become less accessible to LGFVs, so issuing offshore USD bonds will make sense for them.”
An alternative for these companies is to issue renminbi debt onshore, and swap the proceeds into foreign currency, but that would add further selling pressure to the renminbi. “Raising the required funding directly in the foreign currency needed is easier and cheaper offshore,” said Lee. “Achieving a broader investor base is an added benefit.”
However, as the number of LGFV issuers increases, so do concerns about the associated risks including China’s political uncertainty and the rising level of defaults in the country.
The world's second-largest economy has been suffering from deceleration, with its economic growth rate falling to 6.7% in second half this year from 6.9% in full-year 2015, hitting a new 25-year low.
Meanwhile, the country’s debt level has climbed. Moody’s estimated that China’s government debt to increase to 43% of its GDP by 2017, up from 32.5% in 2012.
However, Fitch estimates that the total amount of offshore issuance from LGFVs is less than 5% of their onshore debt. Given that, general market view is that LGFVs going offshore do not yet pose a significant systematic risk.
“Default may not be a critical concern in the near term, given the relatively better visibility of policy support from the government. But it would be one on the back of my mind three to five years down the road as policy evolves,” admitted Western Asset’s Peng, who added that it is one of the reasons why in general her firm tends to stick to short-dated bonds.
One pressing concern is the lack of transparency, according to Peng. This relates not only in the companies in terms of their operational data and financial ratios, but also at the local government level in relation economic and fiscal data.
“We can still get hold of some macro-level data if it’s at a provincial or municipal city level, but for a lower-tier local government it’s quite difficult to get data to assess the credit profile of the local government,” Peng said.
Despite the headwinds, observers agree that the supply from LGFVs shows no signs of slowing in 2017 given the number of potential issuers and continued investor demand.
“The interest the market has in China, coupled with a desire for higher yield, will result in the rise of interest in LGFVs,” DBS’s Lee said.
Lower tier provinces and cities are expected to be the more eager to go offshore and the structure of most deals are likely to be direct issuance, or come with a direct guarantee – a trend that is already started taking place this year, said bankers.
From the issuer’s point of view, DBS’s Lee argues there are three factors that are crucial for the sustainability of LGFV issuance in the coming year.
Firstly LGFVs’ ability to tap offshore markets depends on getting approval. The Shanghai Stock Exchange has stipulated that LGFVs that generate more than half their revenue from local governments will no longer be allowed to issue corporate bonds. While there’s no sign of the NDRC slowing down approvals for the vehicles to go offshore, it will be tricky to predict the regulators’ next move.
“The social and political situation in China is so hard to predict that you never know what’ll happen tomorrow. That worries me,” said a US based research analyst.
Supply also depends on the availability of onshore funding, according to Lee, who added that in the middle of 2015, onshore funding became cheaper, and it took away supply from the offshore RMB and dollar bond markets. “And that trend continued into the first half of 2016. If access to onshore funding becomes tougher, offshore supply will increase,” said Lee.
Last but not least, since most LGFV issuers’ credit is enhanced by clear government support, any adverse change in this support which may lead to resulting credit stress will affect market demand.