China’s Bond-Yield Curve Gets Bent Out of Shape

 Investor sentiment is mixed after Beijing’s campaign this spring to make Chinese markets less risky, with yields on seven-year government bonds rising above yields of both five-year and 10-year bonds.

Source: The Wall Street Journal

China’s $1.7 trillion government-bond market is turning ever weirder. In a fresh sign of the nerves among investors caused by Beijing’s campaign this spring to make Chinese markets less risky, the yield on seven-year government bonds rose to 3.79% on Monday, above the yield on both five-year and 10-year bonds.

The highly unusual move means that China’s government-bond yield curve now resembles a triangle, with the seven-year yield at its highest since October 2014. Yield curves show the interest rates investors are willing to receive when they buy bonds of differing maturities.

The shift comes less than two weeks after the government-bond yield curve became inverted for the first time on record, with 10-year yields—now at 3.65%—lower than those for five-year bonds, currently at 3.68%. Normally investors demand higher yields on bonds that have longer to go until maturity.

“We are seeing a butterfly on our screen that we have never seen before,” said a Shanghai-based senior bond trader at a local mutual fund. An inverted yield curve usually reflects investor pessimism about a country’s long-term growth and inflation prospects. But in China, few are predicting prolonged deflation or recession, despite signs the economy could slow this fall.

Instead, the market’s latest quirk has come about partly because trading in Chinese government bonds of some maturities, such as the seven-year, tends to be quite low in volume. That trend has been exacerbated in recent weeks amid strenuous efforts by Chinese regulators to tame speculative investment using heavy levels of borrowed funds. As investors have sold off their bonds, or simply stopped trading them, price movements have become more erratic.

“It’s mostly due to the fact that the seven-year bond is less liquid. That’s why its yield can be easily pushed up in a selloff,” said Wang Jing, deputy general manager of the fixed income department at Shenzhen-based China Securities Credit Investment Co.

The yield-curve anomalies also have their roots in longstanding structural flaws in China’s bond market, already the world’s third-largest and pivotal to Beijing’s effort to modernize the way its economy is financed. Contributing to the lack of demand in seven-year bonds, for example, is the fact China’s government-bond futures market, where investors can hedge their cash bond holdings, has contracts for five-year and 10-year bonds only, Mr. Wang said. Similarly, trading in China’s interest-rate swaps, another popular derivatives product, is active only up to five years, said the Shanghai-based senior trader at the mutual fund.

In contrast, the prices of benchmark 10-year government bonds are cushioned by demand from long-term investors such as insurance firms and banks, said Suan Teck Kin, an economist at United Overseas Bank in Singapore.
The recent price distortions in China’s bond market, from the curve inversion to the latest “butterfly” look, also betray structural issues such as the lack of a diverse group of participants, including foreign investors, Mr. Suan said.

According to data provider WIND Info, foreign investors now hold 754.8 billion yuan ($109.6 billion) of bonds in China’s domestic market, representing 1.3% of the total. A more diverse investor base would bring in fresh perspectives to the market, potentially allowing for better price discovery.