A year after China's financial regulators squared up to the systemic perils of "shadow banking", the threat is shifting to a booming corporate bond market, and risky borrowers' debt is finding its way into products aimed at retail investors. An opaque network of trust companies and non-bank lenders had grown their annual market to a hefty 2.9 trillion yuan ($450 billion) in loans before regulators stepped in, spooked by rising defaults on wealth-management products (WMPs) backed by such high-interest shadow lending.
Now the high-risk borrowers who took those loans, such as unlisted real-estate firms struggling with a stagnant property market and financing companies backing shoddy local government investment, are finding a new avenue of funding after regulators began allowing unlisted companies to issue bonds on public exchanges. New corporate bond issuance leaped to 914 billion yuan in the third quarter, accounting for 29 percent of all new credit, up from 381 billion yuan and just 8 percent in the first.
And the profile of new borrowers looks strikingly like the patrons of the shadow banking set. Of the 57 firms posting bond listing announcements in Shanghai in October, 23 were local-government-owned project or infrastructure investment firms.
Beijing engineered the freeing up of the bond markets as a transparent alternative funding route, and the credit crunch that followed its clampdown on shadow banking guaranteed a high take-up. But wealth managers are now turning these bonds into leveraged high-yielding products and selling them to investors desperate for returns after a real-estate slump and summer stock-market crash.
Data from CN Benefit, a research firm tracking wealth management sales, shows that 60 percent of new bank wealth-management products (WMPs) were linked to debt and money market instruments in September, up from less than half in the first quarter. Demand is hot for these products, and the higher the yield, the higher the risk, which is amplified if the fund's assets are partly bought on credit, or leveraged.
Colight Asset Management, a private fund offering bond-backed WMPs, raised more than 40 million yuan in just four days in November from an 8.7 percent yielding, 400 percent leveraged bond-based product, according to customer service staff member Chen Xun. Much bigger companies such as Pacific Asset Management Co and the Agricultural Bank of China also offer similar high-yielding leveraged products. Investors, however, assume that products offered by big names are relatively safe.
"The risk of default is very slim," said a 45 year-old business manager in Shanghai surnamed Pan who invests in WMPs on an exchange backed by China's second-largest insurer, Ping An Group. "I'm sure such a big company as Ping An will make sure investors can get their money back." Inflows to bond mutual funds have also risen. Typical of such funds is the Great Wall Long Term Profit Gradated Debt Fund, whose top three holdings are all sub-AAA-rated local government fundraising company bonds. The firm adds leverage by borrowing cheaply in the bond repurchase (repo) market, fund documents show.
"So for instance you can take 2 billion yuan of government debt as collateral and receive 750 to 800 million of cash, and use that to buy more debt," said an underwriter at an international bank in Shanghai who asked not to be named. About half the Great Wall fund's 19 percent return since late 2014 has accrued since July, a period when repo transactions in Shanghai soared, and the spread of AA corporate debt yields over Chinese treasuries fell 60 basis points to four-year lows. Analysts say the narrowing corporate risk premium combined with weakening profits is a red flag for speculative activity.
"Similar to what happened in China's stock market earlier this year, the rally of bonds is largely driven by liquidity conditions and speculation that government will provide support when necessary," said Zhou Hao, Senior Emerging Markets Economist at Commerzbank in Singapore. Some industry professionals worry that these trends, enabled by regulatory reform, will create forces that regulators can't handle when market sentiment turns, in an echo of the stock market boom that preceded the summer crash and a frantic series of heavy-handed interventions by Beijing.
"If, as seems likely, the government has succeeded in getting funding to higher risk sectors by relaxing bond approvals," wrote Christopher Wood of brokerage CLSA in a recent note, "it is all rather scary, given the regulatory failures exposed by the A share boom-bust cycle."
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