The promise of a "comprehensive" package from China to address local debt issues has prompted a rush into bonds issued by local government financing vehicles (LGFV), as investors perceive an implicit state guarantee for these provincial firms. Yields on LGFV bonds, which account for half of China's corporate bond market, have fallen to their lowest levels this year, despite the fact that most of them are exposed to a debt crisis in the property sector.
Spreads on one-year AA-rated bonds over comparable government bonds have dropped from 353 basis points (bps) at the start of the year to around 173 bps, the smallest gap since late 2020, according to data from Chinabond, a platform part of the China Central Depository and Clearing.
Despite growing signs of fiscal stress for local governments, whose primary sources of income are infrastructure and land sales, both of which are sputtering, the narrowing of spreads is more pronounced in lower grade LGFV bonds.
The $9 trillion debt pile of LGFVs, which includes loans, bonds, and shadow credits, is seen as a growing source of systemic risk in China's financial system, particularly with the economy in such poor shape.
However, investor confidence in the country's roughly $1.9 trillion in LGFV bonds returned following China's July Politburo meeting, during which top policymakers expressed a desire to develop a comprehensive scheme to address local debt risks.