Why 2019 is a good year for LGFV issuers and investors
Despite concerns surrounding recent defaults and wavering government support, China’s local government financing vehicle (LGFV) issuers are gaining increasing traction in the US dollar bond market.
The appetite for offshore LGFV bonds is chiefly driven by the confidence in the sector from Chinese investors.
“There is a shift in investor sentiment. (International) investors are now gradually allocating towards LGFV bonds,” says Angus To, executive director and deputy head of research at ICBC International, at The Asset’s 13th Asia Bond Markets Summit in Chengdu, China.
According to To, it is not likely there will be a lack of supply of LGFV bonds in the offshore market.
“As the US Fed stops rate hikes, the stabilization of interest rates will also support LGFV US dollar issuance. The risk preference towards LGFV bonds will change as we see lower interest and yield of primary issuance,” says To.
In addition to refinancing needs, local government spending demand still remains with a number of infrastructure and property development projects in the pipeline.
“We believe that there is a gap between fiscal income and the investment needs of local governments. This gap is unlikely to be filled by municipal bonds. But clearly, the central government is making efforts to regulate the illegal support from local governments,” agrees Li Ma, managing director at Moody’s Investors Service.
According to Samuel Lyu, general manager of the government finance rating department at China Chengxin International, despite a lower onshore financing cost compared to the offshore market, LGFVs still have a strong reason to go offshore.
“From a long-term perspective, when issuers open new financing channels, they have more financing options in the future,” says Maggie Ren, executive director, deputy head of debt capital markets at Huatai International Financial Holdings.
“It is also a good marketing practice for local governments to promote their local business environment and create more communication opportunities for local corporates and international investors. In this way, local governments can attract foreign investment and boost their local economy,” says Ren.
No worries about late payments
In February 2019, Qinghai Provincial Investment Group failed to make a US$11 million interest payment for an offshore US$300 million bond, which marked the first time in 20 years that a state-owned Chinese company had failed to make a payment on its debt burden.
S&P Global Ratings soon downgraded the group to “CCC+” from “B+”, partly due to fears that the Qinghai government’s support would falter over time.
For many Chinese investors, when local governments (or LGFVs) are late with making coupon payments, it is not surprising.
In China, local governments often have to spend large cash expenditures at the end of the year, such as paying salaries or the capital outlay for infrastructure investments.
This latter expense is often motivated by local officials wanting to meet infrastructure investment targets to garner favour when political promotions are up for grabs.
Meanwhile, for cash-strapped local governments that need to apply for additional financing from the central government, the drawdown takes time. As such, issuers may not be able to fulfil their coupon payment obligations on time.
While a technical default normally triggers large selloffs, Chinese asset managers believe that selloffs lead to buying opportunities, especially as they strongly believe that the issuer will eventually pay the principal and interest back.
Qi Zhu, executive director, deputy head, asset management department at Orient Finance Holdings, believes that the probability of a massive blow-up of the LGFV sector is very low, which is a common view among Chinese investors.
“It is likely that China will stabilize some sectors that are strongly tied up with China’s macro economy, which we believe will be property and infrastructure. Chinese investors’ faith in macro beta will not disappear in the short term.”
In spite of recent defaults, sales volumes in 2019 for the LGFV sector are hovering at record highs. As of May 9, Chinese LGFVs issued over US$5.9 billion worth of bonds offshore, up by over a fifth from the same period in 2018, according to Bloomberg.
Furthermore, international investors are no longer shying away from this less transparent sector. In a report issued during April, UBS selected LGFV bonds and central state-owned enterprises (SOE) bonds as their preferred investment-grade bond investment.
Regarding the valuation methodology used for this less transparent sector, Zhu says that his company adopts different approaches towards LGFVs in different industries.
“LGFVs, broadly speaking, include expressway companies. LGFVs, narrowly defined, refer to those companies which help local governments get land. For expressway companies, we apply both bottom-up and top-down approaches. But if it is the latter type of LGFV, then looking at financial results is not helpful,” says Zhu.