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.”
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.
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.”
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.”