The People’s Bank of China headquarters (right) is seen in the financial district of Beijing. The PBoC has been selling reverse repo agreements in open- market operations since late June, injecting a net 90bn yuan into the banking system.

Bloomberg/Shanghai


Chinese investors, who rushed for the exits when a debt-fuelled stock rally ended, are now ignoring worsening credit profiles to buy corporate bonds with borrowed cash.
A rally in five-year AA notes has cut their yield premium over the sovereign to the least since 2010, as trading on the interbank market surged 28% in July. With the overnight repurchase rate averaging 1.2% in the past two months and the yield on the riskiest Chinese bonds well over 5%, carry trades in which debt is bought with loans are attractive, says Shanghai CFETS-ICAP International Money Broking Co.
“The bond market’s performance will improve in the second half as funds seeking stable returns flow back,” said Guo Jun, a fund manager at Bosera Asset Management Co, which oversees 302.8bn yuan ($48.8bn). “In terms of investment strategy, one is to leverage up through carry trade.”
The rally is helping central bank governor Zhou Xiaochuan’s efforts to lower corporate borrowing costs as he balances the need to stimulate demand while avoiding the creation of more asset bubbles. Investors are plowing into corporate debt even as the number of borrowers hit by rating downgrades jumped 21% in the first half of this year amid the slowest economic expansion in six years.
Real-estate company Beijing Tian Heng Development Group sold AA rated five-year securities at 4.12% on July 22, lower than the 5.22% on similar debt in the secondary market.
Onshore issuance of corporate bonds, government debt and certificates of deposit have surged to 10tn yuan so far this year, close to the 11tn yuan in the whole of 2014. The government is allowing provinces to sell debt directly to help refinance the debt of regional finance vehicles, many of which are rated AA.
Policy banks may sell at least 1tn yuan of bonds to fund construction projects, according to people familiar with the matter. The first batch will be 300bn yuan, the official Xinhua News Agency-backed Economic Information Daily reported Wednesday, citing a document it said it obtained.
“As funds shift to the bond market from stocks, issuers are benefiting from the spike in demand,” said Wang Ming, chief operations officer at Shanghai Yaozhi Asset Management, which oversees 4bn yuan of fixed-income securities. “The fresh inflows helped to alleviate the pressure on the market amid huge supplies.”
The yield on five-year AA rated bonds fell to 5.11% on July 24, the lowest since October 2010, and its premium over government notes dropped to 192 basis points on August 3, ChinaBond data show.
The yield on AA- notes declined to 5.31% on July 29, the lowest since November. Gradings of AA-or below are equivalent to non-investment ratings globally, according to Haitong Securities Co.
Declining yields don’t necessarily translate to safety. A total of 69 borrowers were downgraded in the first half of 2015, compared with 57 a year earlier, according to SWS Research Co, a unit of Shenwan Hongyuan Group Co. Companies in the metals and coal industries were the most affected amid reduced demand.
Winsway Enterprises Holdings, an importer of coking coal that defaulted on its US currency debt in May, said on Monday it has extended a standstill agreement pending discussions with bondholders and other parties.
“Investors should be cautious about low-graded companies,” said Bosera’s Guo. “Yields shouldn’t be the only thing to look at. We should still look at financial statements, and those doing well deserve low financing costs.”
The benchmark Shanghai Composite Index of stocks fell 14% in July, the biggest slide since August 2009. The gauge dropped 10% last week and 1.7% yesterday.
China’s overnight repurchase rate dropped to a six-year low of 0.99% on May 29 after the PBoC reduced benchmark interest rates and cash reserve ratios for banks.
 The gauge of interbank funding availability climbed for a record 25th day to 1.49% yesterday, the highest since May 5, a weighted average from the National Interbank Centre shows.
Amid demand for carry trades, turnover of the contracts rose 18% last month from June, accounting for 90% of all pledged repo trades, up from 84%, according to Bloomberg calculations based on National Interbank Funding Center data. The PBoC has been selling reverse repo agreements in open- market operations since late June, injecting a net 90bn yuan into the banking system.
“The carry trade is based on assumption that liquidity will remain flush in the interbank market,” said Becky Liu, a rates strategist at Standard Chartered  in Hong Kong. “When there is a change of this expectation, the impact on the bond market will be amplified due to the leveraged positions.”
China will step up targeted macro policy control to counter downward pressures on growth, the Xinhua News Agency reported July 30 following a Politburo meeting chaired by President Xi Jinping.