Local government finance vehicles (LGFVs) issued in China are a burgeoning sector offering investors opportunities that are too good to miss – their complexity is a deterrent for many investors but this just creates more opportunities to identify value
LGFVs first came into existence in the 1990s but it was not until March 2014 that the first US dollar bond was issued. Today, the market capitalisation of LGFVs has surged to $15bn and they now account for 2% of the JPMorgan Asia Credit index (JACI) and 5% of the JACI Corporates sub-index.
While many LGFVs are rated high-yield, they can receive between two to eight notches of credit uplift by rating agencies on the basis that they receive implicit support from local Chinese governments.
The sector should benefit from China’s increased reliance on infrastructure to support growth this year as the other main growth driver – property – appears to be waning from its cyclical peak in 2016 amid increased regulatory restrictions.
Market technicals are positive; at least half of new LGFV issuances are snapped up by onshore Chinese banks and asset management companies, making the sector less vulnerable to swings in international sentiment.
In identifying the most attractive bonds, NN IP favours issuers that have a good standalone credit profile, for example, an LGFV that might already have an investment-grade rating before taking into account any uplift from government support.
Secondly, NN IP likes LGFVs that are likely to receive support from the central government. In general, LGFVs from China’s provinces and municipalities take precedence over the capital cities, which are in turn more crucial than small cities and counties. LGFVs with assets that play a part in the national strategy are also more likely to be supported.
On-the-ground knowledge is essential to analyse the myriad factors that affect LGFVs. Investors must also keep ears to the ground to stay up to date on China’s strategic policies and regulations. One thing for sure is that China’s LGFV sector will continue to grow, bringing substantial opportunities to the alert investor.
Leo Hu is senior portfolio manager at NN Investment Partners