Chinese bond yields march higher as default worries grow

SHANGHAI: Chinese bond yields extended their three-week long march higher this week, as rising worries about corporate creditworthiness and a less aggressive easing stance by the central bank drained liquidity from the fixed income market.

Benchmark treasury three- and five-year treasury yields are now up over 20 basis points since the beginning of April, as strong March inflation and activity data have dampened expectations about the pace of monetary easing.

Treasury auction yields have consistently exceeded market expectations in recent weeks.

Corporate spreads have also risen following several high profile defaults, including that of Dongbei Special Steel Group Co Ltd, a state-owned steelmaker located in the northeastern city of Dalian.

The rise has been especially noticeable on the short end of the curve.

The yield premium of A-rated six-month commercial paper over AA-rated paper is up more than 20 basis points since the end of March, following Dongbei´s March 29 default.

Analysts said one reason for the sell-off was mounting uncertainty among investors over which state-owned companies had strong support from the authorities in the event of financial distress.

"Allowing widespread defaults without transparent criteria for selecting debtors who would be allowed to fail, and without a robust, predictable framework for supporting lenders absorbing credit losses, would risk provoking a ´credit crunch´ with significant destabilising effects on the economy and banking sector," wrote Andrew Colquhoun, senior director at Fitch Ratings in Hong Kong, along with other Fitch analysts in a note on Friday.

Adding to signs of tightening credit conditions, Chinese firms have cancelled more than $10 billion of new bond issuance in April so far.

Nonetheless, most analysts believe that in the event of a true credit crunch, monetary authorities would step in sharply to avoid large-scale contagion.

"You had a similar situation in 2014 when it looked like the trusts were about to blow up," said Duncan Wrigley, Head of Research at the economics and policy consultancy NSBO.

"If the risks in the market really threaten to get out of control, then at that stage they intervene.

" China´s central bank injected a net 680 billion yuan ($104.9 billion) of funds into money markets through open market operations this week, the most since January.

The weighted average of the benchmark seven-day repurchase agreement in the interbank market, considered the best indicator of general liquidity in China, was up 12 basis points on the week to 2.44 percent on Friday.

The 14-day rate was up by a much sharper 37 basis points on the week to 3.05 percent.

Although analysts have broadly revised down their expectations for further easing by the central bank following strong March data, most still expect several more cuts to bank reserve requirement ratios (RRR) this year.

Rising yields in the bond market, which raise refinancing costs for heavily indebted corporates, could hasten that decision.

"Despite signs of significantly improving growth momentum in March, the structural headwinds from housing oversupply, high leverage and overcapacity reduction will remain over the rest of this year," wrote Nomura economists in a note following the March data release.

"We continue to expect three more 50 basis point reserve requirement ratio cuts and one 25 bp benchmark interest rate cut over the rest of this year.