(Bloomberg) -- China’s off-the-books local government debt market has turned. Only a few months ago, the sector was flagged as the number one financial risk in Asia, but now borrowing costs have fallen to a record low as investors grow confident authorities will bail out any operations that run into trouble. 

In the first half of 2023, local government financing vehicles were paying coupons of well above 4% as concerns about the risk of potential defaults mounted. The average coupon in April on new debt fell to just 2.83% — the lowest level in data going back to 1999 collected by Bloomberg.

The turnaround comes despite the fact that many of the core issues afflicting LGFVs haven’t gone away. The property slump has slashed income from land sales while public budget deficits jumped during the pandemic. Half of cities experienced difficulty in managing debt interest payments last year, Rhodium Group said.

But a series of interventions from the Chinese government, including a large-scale refinancing program and a push to get banks to extend loans, have gone beyond market expectations. Trust companies, China’s de facto shadow banks, have also aggressively increased lending, according to people familiar with the situation who asked not to be identified.

“We believe the Chinese government is unwilling to let LGFVs experience a similar downturn to the housing sector,” said Yifei Ding, portfolio manager at Invesco Hong Kong Ltd. “LGFVs are relatively safe in the short term.”

The shift in mood has been so swift that some LGFVs have seen their borrowing costs effectively halve in just over six months. Last September, Guiyang Investment Holding Group Co., based in underdeveloped Guizhou province, had to pay a coupon of 6% on its 2028 bond. In March, it sold a 2029 bond with a coupon of just 3.1%.

Government Action

The ratcheted-up central government support has mostly been delivered to financial institutions through internal documents or so-called window guidance.

Key policies include the extension of a financing support program for 12 provinces and municipalities to other debt-laden cities, and the establishment by the central bank of an emergency fund program to help ease repayment risks of maturing debt, according to people familiar with the situation who asked not to be identified discussing non-public information.

Additionally, provincial-level governments have also been told to ensure that LGFVs can refinance their bonds due before the end of 2024, helping convince investors that authorities are prepared to step in to prevent any default.

That’s a notable change from a year ago when there were widespread worries that payment delays from some weaker borrowers could be a prelude to a cascade of defaults and the central government might be reluctant to intervene.

“To some extent, LGFVs serve as the hallmark of China’s sovereign credit,” said Wenjie Hou, deputy general manager of Hui Yuan Ying Fund, a Shanghai-based private fund specializing in credit bonds. “A bailout would inevitably be deployed when systemic risks are at stake.”

There has also been a resurgence in financing activities from Chinese banks and trust companies. Two top trust firms have increased their financing to LGFVs by nearly a third in the first quarter, according to people familiar with the situation who asked not be identified.

That trend is confirmed by publicly available data, with trust products used to finance LGFVs hitting a four-year high of 138 billion yuan ($19.1 billion) in the first-quarter of 2024 according to Use Trust, a company that tracks the industry. (Its data only cover trusts sold to retail investors and not private placements which make up the bulk of LGFVs financing via trusts, so it will significantly understate the volume of money flowing in.)

Beyond Expectations

“These government actions have beaten market expectations,” said Sun Zhigang, fixed-income fund manager at Zheshang Fund Management Co. “The buying frenzy from investors is likely to continue, particularly for the LGFV debt issued by those key provinces that will benefit more from central funding support.” 

The market has also benefited from tightness of supply, with regulators terminating applications for 53 new LGFV bonds with a combined 75.2 billion yuan between January and February, according to S&P Global Ratings data. The continued weakness in the equity and housing markets also makes other alternative assets less appealing.

Taken together, all of these factors have pushed down spreads on low-rated LGFVs notes to a record low. Central bank governor Pan Gongsheng said Friday China has effectively mitigated local-government debt risks, based on improved settlement of government debts owed to companies, falling levels of off-budget debts that have implicit government guarantees and a decline in the number of LGFVs.

To be sure, LGFVs, which need to pay back a record 4.65 trillion yuan of maturing local bonds this year, are far from risk-free. While the government’s support package has stabilized the market for now, the fundamental economics still look daunting as the property crisis has crippled municipalities’ ability to make money from selling land, a key source of income. 

Still, the chatter among local investment managers right now is not about risk, but whether there is enough profit in the trade.

“Compared with bonds of China’s state-owned companies and other investment-grade bonds worldwide, LGFV dollar bonds’ spreads don’t have a big pickup,” Invesco’s Ding said. “So in terms of relative value, it’s a bit challenging for us.”

--With assistance from Shuiyu Jing, Shuqin Ding and Yuling Yang.

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