Chinese bankers say a debt-driven bond market rally is starting to show the same signs of overheating that preceded a collapse in equities.
Repurchase transactions allowing investors to use existing note holdings as collateral to borrow money for one day doubled in the past year to a record 2.1 trillion yuan ($330 billion) on Monday. The cost of such funding in the interbank market has risen to 1.89 percent from a five-year low of 1 percent in May and has swung violently before, reaching 11.74 percent in June 2013. A similar contract on the Shanghai stock exchange climbed to 2.21 percent as equities rallied. Credit spreads at the narrowest in six years are being questioned as a steel trader delays making debt payments.
“There are signs of an overheating market, and certainly the rally can’t last for long,” said Wei Taiyuan, an investment manager at China Merchants Bank Co. in Shanghai. “Leverage in the bond market is much higher than at any time in history. If equities continue to perform well, or initial public offerings resume, the liquidity-fueled rally may come to an end.”
Among the potential triggers for a correction is state-owned steel trader Sinosteel Co.’s failure to make an interest payment originally due Tuesday on 2 billion yuan of bonds maturing in 2017. The company previously postponed a date at which investors could demand early repayment. Competition for funds is increasing as the best weekly rally in stocks since June has led to the biggest growth in margin debt for buying equities in half a year, which risks diverting money away from money markets.
The yield premium of five-year AAA rated corporate bonds over similar-maturity Chinese government debt fell to 84 basis points on Sept. 7, the least since 2009. The spread widened to 93 basis points on Monday, compared with an average of 144 over the past five years. The Shanghai Composite Index of shares climbed 6.5 percent last week and has rebounded 17 percent from this year’s low in August.
China’s gross domestic product expanded 6.9 percent in the three months through September, the slowest pace since 2009, and bond defaults rose due to sliding corporate profits. Companies including solar firm Baoding Tianwei Yingli New Energy Resources Co., sausage maker Nanjing Yurun Foods Co. and China National Erzhong Group all encountered repayment difficulties. Non-performing loans in the first six months totaled 249.3 billion yuan, almost matching the total for the whole of 2014.

‘Turning Point’

“The credit market is at a turning point,” Roy Le, chief dealer at Bank of China Ltd.’s RMB Trading Unit in Shanghai, said in an interview last week. “As the number of defaults was very limited previously, credit premiums are distorted, but now such cases are rising, the premiums and ratings will change accordingly.”
The People’s Bank of China has cut interest rates five times since November and eased lenders’ reserve requirements to help minimize financing difficulties as the economy slows. Premier Li Keqiang urged financial institutions to keep liquidity at a reasonable level to ensure adequate credit growth during an Oct. 16 meeting in Beijing. He also called on the sector to provide “necessary funding” to companies in temporary difficulties that have promising prospects.
Policy makers’ efforts to lower funding costs have made it possible for traders to repeatedly pledge bond holdings to obtain loans, and use the borrowed money to buy more notes to magnify profits. Monthly repo transactions as a ratio of all outstanding debt onshore, an effective gauge of leverage, climbed to an all-time high in the third quarter, according to Wei at at China Merchants Bank.
“The risk for a correction can’t be ignored,” he said.
The Ministry of Finance auctioned 10-year securities at the lowest coupon in almost seven years last week, as the yield on the secondary market declined to 3.04 percent on Oct. 14, the lowest since 2009.
“People shouldn’t place too much hope that the 10-year yield will fall below 3 percent before year-end,” Ming Ming, a fixed-income analyst at Citic Securities Co., wrote in a report Tuesday. “The lesson learned in the stocks plunge is that an asset price bubble would be a significant side effect of excessively loose monetary policy,” said Ming, who previously worked at the PBOC.
The Shanghai Composite Index of stocks climbed to the highest level in two months on Tuesday, as China’s margin debt outstanding balance rose for seven straight days, expanding 5.3 percent last week, the most since April. The benchmark gauge slid 29 percent in the third quarter, the biggest loss since 2008 as leveraged positions unwound.
The interest rate for overnight repos on the Shanghai Stock Exchange, which can be used to finance both stock and bond investments, has averaged 2.24 percent in October, up from 0.89 percent in the third quarter.
If the bubble in the bond-market bursts, the damage to the economy would be bigger than the stocks slump, said Gao Shanwen, chief economist at Essence Securities Co. in Beijing. “It could hurt lending and the real economy, as banks suffer from capital losses and become less willing to lend.”