Ban on Muni Bond Sales Ended Amid Bad Debt Concern: China Credit

From Bloomberg Business WeekBy Fion Li, Judy Chen and Henry Sanderson

Oct. 20 (Bloomberg) -- China will allow some local governments to issue bonds independently, ending a 17-year ban that prompted authorities to set up thousands of companies that racked up $1.7 trillion of liabilities by the end of 2010.

The cities of Shanghai and Shenzhen, and the Zhejiang and Guangdong provinces will be able to sell debt themselves instead of going through the central government, according to a Finance Ministry statement yesterday. Nine of China’s 10 worst- performing corporate bonds in the past month were issued by local-government financing arms, with the 11.5 percent slide in Inner Mongolia Nailun Group’s 2018 notes leading declines. U.S. municipal debt dropped 0.2 percent in the same period, based on Bank of America Merrill Lynch’s Municipal Master Index.

Local governments in China set up the companies to fund the construction of roads, sewage plants and subways after they were barred from issuing bonds and obtaining bank loans directly under a 1994 budget law. A June report by the National Audit Office said there were more than 6,500 entities with debt, 42 percent of which would fall due in 2011 and 2012.

“This sends a strong signal that the central government is determined to find a solution to resolve local debt problems,” said Qu Hongbin, chief economist for Greater China at HSBC Holdings Plc in Hong Kong. “It also opens a door for widening long-term financing channels for local governments.”

The biggest declining local-government unit bonds lost 6.6 percent on average in the past month, according to Shanghai Stock Exchange data compiled by Bloomberg. Weinan City Construction Investment and Development Ltd.’s 6 percent debt due in June 2017 were the worst performers after Inner Mongolia, losing 9.3 percent.

Bad Debt

Local government financing units owed about 3.5 trillion yuan ($548 billion) more than was reported by the state auditor, Moody’s Investors Service estimated in a July 5 report. China’s non-performing debt may account for as much as 12 percent of total credit, Moody’s said. As much as 30 percent of local government liabilities may go sour, Standard & Poor’s said in May.

“Most of the provinces have balance-sheet mismatch as they have borrowed short to fund long-term investment,” said Chi Lo, chief executive officer at HFT Investment Management (Hong Kong) Ltd. Even without central government guarantees, borrowing in the bond market is likely to prove cheaper than taking out bank loans, he said.

China’s State Council will limit the amount that can be raised by local governments in the trial program, and the Finance Ministry will handle payments for securities issued this year, without providing an explicit guarantee, the statement said.

‘Hidden Risks’

State-run fund Central Huijin Investment Ltd., which holds stakes in most of China’s financial institutions, said last week it would boost its holdings in the nation’s four biggest state- owned commercial banks after their shares slumped amid concern that bad debts will climb. Industrial & Commercial Bank of China Ltd. and China Construction Bank Corp., the world’s two biggest lenders by market value, have dropped 30 percent and 27 percent this year in Hong Kong.

“It’s undeniable that the lack of supervision and management of local government financing vehicles have created some hidden risks,” Liu Mingkang, China’s banking regulator said, according to a transcript of a speech posted on the body’s website yesterday.

The State Council approved the Finance Ministry selling 200 billion yuan ($31 billion) of bonds on behalf of local governments in March. Zhejiang has approval to sell 8 billion of debt yuan this year, the province’s fiscal department said in a faxed response to questions on Oct. 18. Shanghai was allocated 7.1 billion yuan, while Guangdong has 6.9 billion yuan, Caixin Magazine reported on its website on Oct. 10.

Default Risk

A total 22.9 billion yuan of notes are still to be sold in 2011 by the four local authorities included in the the trial program, according to Caixin.

Officials at Guangdong province’s media office didn’t respond to faxed questions sent by Bloomberg News this month, while phone calls to the finance offices of Shenzhen and Shanghai weren’t answered. Xinhua News Agency reported in September that those cities and provinces had won permission to sell debt directly.

“Whether it’s worth buying these type of bonds will depend on their guarantees, be it tax revenue or cash flows from certain projects,” said Chen Qiwei, a senior bond trader at Shenzhen Development Bank Co. in Shanghai. “Certainly we are concerned about the issuer’s default risks.”

Default Swaps

Yields on 10-year Chinese government bonds have slipped from a three-year high of 4.13 percent reached on Aug. 30 and were at 3.73 percent yesterday. The yuan weakened 0.1 percent to close at 6.3855 per dollar yesterday in Shanghai, according to the China Foreign Exchange Trade System.

The cost of insuring Chinese sovereign bonds doubled this year as ratings companies highlighted the growing risk of loans to local-government financing vehicles and property developers. Five-year credit-default swaps on the notes were 144 basis points yesterday, up 76 basis points in 2011, according to data provider CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market.

The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent should a government or company fail to adhere to its debt agreements.

The debt to be sold under the trial program will have maturities of three and five years, according to the ministry’s statement. The authorities involved can choose their own underwriters to arrange the sales.

Helps Banks

Guangdong has the highest gross domestic product among China’s 23 provinces at 4.6 trillion yuan in 2010, according to data compiled by Bloomberg. Zhejiang’s GDP climbed 21 percent to 2.8 trillion yuan last year, while the city of Shanghai’s economy was valued at 1.7 trillion yuan, the data show. The GDP of Shenzhen city was 951 billion yuan.

China’s overall GDP was $5.9 trillion last year, data collated by Bloomberg show.

“The trial program starts from places with relatively better fiscal conditions,” Fan Jianping, director of economic forecasting at China’s State Information Center, said by phone from Beijing yesterday. “Local governments will be able to gradually repay indirect borrowings, including bank loans, by raising funds from direct bond sales.”

Since March 2009, the Finance Ministry has issued bonds on behalf of cities and provinces collectively, repaying principal and interest. The ministry sold 17.6 billion yuan of three-year bonds this week at a yield of 3.67 percent on behalf of regional authorities, down from 4.01 percent at the last sale on Aug. 22. The yield on the central government’s benchmark three-year bonds fell 2.5 basis points to 3.48 percent today, Chinabond data show.

“Issuing bonds doesn’t solve the fundamental problem but it does help the banks because now the onus is not just on them,” said Yao Wei, a Hong Kong-based economist at Societe Generale SA. “The risk will be spread to other investors.”

--Fion Li, Judy Chen and Henry Sanderson. With assistance from Belinda Cao in New York. Editors: James Regan, Emma O’Brien

To contact the reporters on this story: Fion Li in Hong Kong at fli59@bloomberg.net; Judy Chen in Shanghai at xchen45@bloomberg.net; Henry Sanderson in Beijing at hsanderson@bloomberg.net

To contact the editors responsible for this story: Sandy Hendry at shendry@bloomberg.net; Shelley Smith at ssmith118@bloomberg.net

From Bloomberg Business Week

How to use bonds to cut investment risk

When paired with stocks, bonds diminish risk without crimping long-run returns. Forget fancy formulas -- 60/40 or 70/30 works for just about everybody. Here’s how to get started.

By Scott Gerlach

For the vast majority of investors, bonds serve a single, overriding role -- as ballast. True, bonds function well for income seekers, and, in the hands of an adept speculator, they can beat the stock market for long stretches. But most importantly, bonds help keep a stock-focused portfolio sturdy -- steadily, predictably sailing toward long-run returns.

Bonds suffered neglect during the 1990s bull market in stocks. Investors parked ever more of their assets in equities, afraid to miss out on the rocket ride. But when the rocket crashed in 2000, stocks-only portfolios shattered. Better-diversified accounts, however, enjoyed much of the moon shot without the crash landing.

Find the right mix

The first fixed-income question for most investors is, what's the right ratio of bonds to stocks?

Michael Holland, who manages the Holland Balanced fund (HOLBX), strongly advocates a 60/40 ratio of stocks to bond for most investors. With this mix, investors can expect 80% of the stock market's long-run return but with a truly moderate level of volatility.

Holland's fund offers something of a test lab -- and wouldn't be hard to emulate. It's split almost exactly 60/40, with the stock component spread over about 20 blue chips and the bond portion almost exclusively in Treasurys, the rock-solid bonds issued by the U.S. government. (Holland's tiny fund had only $50 million under management in early 2003. His marketing consists of one Wall Street Journal ad once a year, plus annual ads in the magazines Harvard and Nantucket. He says his 2,500 or so holders never sell.)

A $10,000 deposit in Holland's fund in April 1997 (its inception) was worth $11,711 in January 2003. An identical deployment in the Vanguard 500 Index fund (VFINX) amounted to $12,162. In 2001, when the S&P 500 ($INX) index skidded 11.1%, Holland's balanced fund edged down just 0.2%.

Interested in even more security than the Holland formula offers? The minimum-risk allocation mix probably is 80% fixed-income, 20% stock, according to Alan Gayle, senior investment strategist for Trusco Capital Management. Gayle oversees investment policy for a broad array of mutual funds, and he helps manage the $575 million STI Classic Growth and Income fund (CRVAX). In his view, a 100% bond allocation would be ill-advised, even for the most risk-averse investor, as bonds can suffer lengthy bear markets of their own.

Bond allocation guidelines

Whatever your asset-allocation goal, Gayle offers some guidelines for splitting up the bond portion:

• Start with 25% or more in bonds with as little default risk as possible: Treasurys, inflation-indexed Treasurys or municipal bonds.

• Then add bond funds with "economic exposure," such as those focused on highly rated corporate bonds. These usually outperform Treasurys when the economy heats up. (A fund offers the diversification few investors achieve with individual corporate bonds.)

• Don't neglect junk bonds. They deserve at least 10% of your bond investment. They correlate more closely with equities than with fixed income, and their higher yields can compensate when Treasury yields are low. Funds are the only way to play the high-yield market.

The safest bond

The safest choice of ballast material for your portfolio is Treasurys (and inflation-protected Treasurys). Only rarely do Treasurys offer the fixed-income world's biggest returns. But their issuer -- Uncle Sam -- won't be going bankrupt. Here are the best ways to buy them:

Directly from the government. The U.S. Department of the Treasury has Web site called TreasuryDirect that allows for the purchase of Treasurys. It's easily accessible to individual investors, and Treasurys can be bought at auction at no fee.

Mutual funds. There are relatively few Treasurys-only mutual funds. But some exchange-traded funds have emerged that are modeled on Treasury indexes. (Exchange-traded funds, or ETFs, are essentially baskets of actual securities that are broken into pieces for individual investors to buy. ETFs offer low fees and have certain tax advantages.) In summer 2002, Barclays Global Advisors launched three ETFs pegged to four Lehman Brothers Treasury indexes: the Lehman 1-3 year Treasury(SHY, news, msgs), Lehman 7-10 year Treasury (IEF, news, msgs) and Lehman 20+ year Treasury (TLT, news, msgs).

Government bond funds. The most common Treasury proxy is the ubiquitous "government bond fund," which usually amalgamates Treasurys, highly rated agency debt (from the Federal Home Loan Bank, Ginnie Mae and other entities) and even short-term corporate bonds. Vanguard, T. Rowe Price and PIMCO offer government funds of various durations with excellent track records. (Just be careful which class of fund shares you buy -- sales loads can be high, particularly from PIMCO.)

Simplicity is the primary advantage of these funds. Writing a check to a fund company takes less effort than buying individual bonds and can, for some investors, be worth a small annual fee. Many financial planners scorn government-bond funds, though. The problem? Few bond funds feature a single maturity date. Most managers buy and sell to take profits or pounce on perceived bargains. The only way to guarantee stability of principal is to buy individual bonds and hold them to maturity. (An exception: American Century offers a series of "target maturity" funds that hold only bonds that mature in a single year. When held until maturity, these funds closely mirror the experience of buying individual securities.)

The municipal alternative

While Treasurys tend to be the first bond category beginning investors consider, they aren't always the best option. Treasurys perform best in tax-deferred accounts, since Uncle Sam treats interest payments as regular income. And they can melt in value during periods of inflation.

One alternative: high-rated municipal bonds. These promise Treasury-like safety from default as well as important tax breaks. Buy bonds issued by municipalities in your home state, and you usually dodge federal, state and local taxes -- the "triple tax free" promise that makes munis favored income vehicles for the well heeled.

Even for the rest of us, munis make good sense. Assume you're in a hypothetical 30% federal tax bracket. A muni yielding 5% earns just as much -- after federal taxes -- as a Treasury yielding more than 7%. In early 2003, 7% Treasurys existed only in the recollections of old-timers.

"If someone were to get a fixed-income portfolio and their money were sufficient, I would think that they should own outright some high-quality municipal bonds," says Trusco's Gayle. He recommends insured or triple-A-rated general-obligation bonds.

The main problem with munis is getting your hands on them. A round lot of any particular bond goes for as much as $250,000. Buy less and you pay a higher markup. Financial planners see $100,000 as just about the smallest allocation that can go into individual munis.

Yes, you can go the mutual fund route, as muni funds accept smaller amounts. But be careful to know exactly what you're buying. "If they're going to own mutual funds, then they need to be examining the prospectus to see what the quality parameters are," Gayle says.

MSN Money offers tools for just such an examination. Start with our Top Performers screens to find consistently performing muni funds focused on your home state. Seek a low expense ratio -- it can be as little as a quarter percentage point -- and a long-tenured manager.

Tips on TIPS

While munis guard your interest from the tax man, TIPS fend off income investors' other bugaboo: inflation. Treasury Inflation-Protected Securities pay a small coupon yearly, plus their principal value is adjusted once a year to match changes in the Consumer Price Index. TIPS are cheapest when the economy is heading south and no one fears inflation. Traders hate them, but buy-and-hold investors find their inflation insurance comforting.

"It's possible sometime in our lifetime we'll have inflation again bite us in the butt," says Holland.

The downside: TIPS present tax problems. The inflation adjustment counts as income in the year it is made, even though investors don't pocket the principal until maturity. Also, TIPS are auctioned less frequently than other Treasurys. The government promises a new 10-year TIPS each July, and it reopens them for new investment in October and January.

In general, TIPS and munis move in sway with Treasurys. They make equally good ballast to counteract stock gyrations.

Reaching for yield

Money managers and investment planners debate the wisdom of sinking your entire bond allocation in low-yielding (but rock-solid) Treasurys and munis. Holland wouldn't have it any other way. But Richard Lehmann, publisher of the Forbes/Lehmann Income Securities Investor newsletter, recommends mixing it up.

Corporate bonds, junk, mortgage-backeds, mid-tier municipals and a host of other higher-yielding options abound. But it's hard or impossible for individuals to buy many of them. Minimum investments are large, and individual bonds carry exponentially more risk than a diversified bunch. Moreover, expensive research tools give professional traders huge advantages in valuing each bond's unique features -- maturity, coupon, call dates, credit rating and more. And unlike stocks, few bonds aside from Treasurys have easily accessible price histories. Fewer than 100 corporate bonds are listed on the New York Stock Exchange.

"In fixed-income investing, it is much more complicated to select the instrument you want to invest in," Lehmann says. "With common stock, everything is the same."

A typical investor seeking diversification and total return has two realistic options: Buy mutual funds or make fixed income a hobby and find a guru like Lehmann to follow. Funds encapsulate every segment of the bond market into bite-size portions, though at the price of a management fee and without a guarantee of principal. Bond newsletter writers, among whom Lehmann is the dean, make specific recommendations but leave the portfolio in your hands.

For simplicity, Trusco's Gayle suggests sticking with highly rated corporate-bond funds. He guides individual investors away from mortgage-backeds because their boom and bust cycles are less predictable. He and Holland offer a few basic rules to guide bond-fund purchases:

• Pick a sensible credit-rating range. Moody's and Standard & Poor's use slightly different scales that appraise corporate bonds from D (in default) to triple-A (zero perceived default risk). Enter a fund's five-letter symbol in the MSN Money quote box, then click Fund Portfolio in the left-hand navigation -- the fund's average credit rating is the first data point you'll see. The PIMCO Total Return Fund (PTTAX), managed with great success by the legendary Bill Gross, has an average rating of double-A.

• Pick a duration that doesn't make you sweat. Each bond fund has an average duration, related to (but different than) the average maturity of the fund's holdings. Duration essentially measures a bond's sensitivity to interest rates. It's given in years. PIMCO Total Return in early 2003 had an average duration of 4.4 years -- a middling number. A smaller figure offers greater defense against rising interest rates; a larger number offers more market sensitivity to declining interest rates.

• Follow the other usual guidelines for buying funds. That means low fees, a reputable manager and a solid track record.

Regular maintenance pays off

Stocks have no ceiling. Theoretically, share prices can rise unceasingly so long as earnings expectations keep growing. But bonds run in cycles. They have ceilings -- and floors. Yields don't fall to zero or rise to infinity.

For that reason, they need to be treated differently than stocks. Watch a few different bond categories over time and you'll quickly learn to capitalize on their individual peaks and troughs. In early 2003, for instance, Treasurys looked very pricey, high-grade corporates were mending and junk bonds had come back from their 2002 collapse. Munis weren't sure what to make of a proposed cut in dividend taxes, which might lower their status among income investors.

But even before you harmonize with the bond universe, you can employ a mechanistic approach. Strike that stocks/bonds mix and rebalance to it once a year. Employ a similar approach with your bond holdings. Pare back winners and reallocate more to losers.

"It's very important not to take your eye off of the goal line," Gayle says.

You'll also have to decide what to do with the interest checks. In tax-deferred portfolios, they're best reinvested to avoid steep penalties.

In non-retirement holdings, income reinvestment helps build up bond allocations more quickly -- though you must weigh the costs and benefits. Interest is taxable in the year it's earned, regardless of whether it's reinvested. And taking income from bonds actually helps cut investment risk even further. If they get ploughed back in to principal, those interest checks are in play. Alternatively, they are beyond the market's reach once they go into cash or get used for everyday expenses.

At the time of original publication, Scott Gerlach owned or controlled shares in the following securities mentioned in this article: PIMCO Total Return.

From MSN Money News

Don't put all your money in a bond fund!

By Walter Updegrave, senior editor

(Money Magazine) -- Question: I consider myself a good 401(k) citizen. I contribute the max, get the company match and have an age-appropriate level of stocks in my account. But one of the bond funds in my plan has a 10-year average return of about 9%, which is better than almost every stock fund. So I'm wondering whether I'd be better off just putting all my money into that bond fund. Would that make sense? -- Dan, Southfield, Mich.

Answer: Things are hardly ever black or white in the investing world. There's almost always an area of gray, more likely shades of gray. Which means it's not often that my answer can be completely unequivocal.

But your situation is one of the rare exceptions, so I want to make the most of this opportunity. Let me see, how should I put this?

No! Don't do it! Bad idea! Absolutely do not move all your money into that bond fund!

Of course, most of your investing compatriots have to one degree or another already been doing what you would like to do -- i.e., avoid stocks and buy bonds. From the beginning of 2009 to the end of last month, investors have poured a staggering amount of new money into bonds and bond ETFs -- more than $615 billion, according to Morningstar. Meanwhile, they've yanked some $3.9 billion from stock portfolios.

But I think you would be making a big mistake to follow their lead and invest your entire 401(k) account in that bond fund.

Why?

Retirement investing: Don't abandon stocks
For starters, it almost never makes sense to put all your retirement savings in one asset basket. You never really know which type of investment is going to provide the most generous returns in the future, so it's a good idea to protect yourself from picking the wrong one by spreading your money around.

If you transfer your entire 401(k) balance as you envision, you would not only be tying your retirement prospects to the performance of one asset class -- bonds -- you would also be pegging your future to the performance of a single fund. Instead of hedging your bets, you would be concentrating them.

But there's another compelling reason you ought to reconsider -- namely, the chances are low at best that the bond fund you find so attractive will be able to repeat its 9% annualized performance in the years ahead.

The reason is that over the past 10 years bond yields have dropped fairly dramatically, falling from roughly 6% or so at the beginning of this decade to less than 4% recently. That decline in interest rates acted as a tailwind for bond funds, creating capital gains on top of interest income and generating those eye-catching returns.

But with interest rates already so low today, the potential for further rate declines and more capital gains is limited to say the least. Ibbotson founder and investing guru Roger Ibbotson made this very point to me in a recent interview on the return potential for stocks vs. bonds.

If anything, investors are more concerned about the opposite occurring -- that is, rates rising and bond prices falling. The point, though, is that while you should never consider past returns a roadmap for the future, bonds today represent a case where past results might be an outright misleading indicator of future performance.

In short, I think you might end up sorely disappointed if you move your stash into that bond fund expecting it to reprise those 9% annual gains over the next 10 or so years.

That said, I don't think, as some people do, that the possibility of rising rates at some point in the future means you should totally avoid bonds or bond funds. As I've noted before, I don't buy into the whole bond-bubble brouhaha, or at least not enough to advise going to the extreme of eschewing bonds altogether. I think doing that would make about as much sense as shunning stocks -- i.e., none.

So what do I recommend that you do?

Basically, you want to spread your 401(k) stash among a blend of stock and bond funds that's right for your situation. You say that you have an age-appropriate level of stocks in your account. If that's the case -- and your stock stake is diversified among large and small stocks, growth and value and maybe a bit of international -- then maybe you don't have to change anything, other than your intention to hop into that bond fund.

But since you're thinking about how to invest your 401(k) money anyway, it's probably not a bad idea to re-evaluate your asset mix.

One way to do that is to see how your mix compares with that of a target-date retirement fund for someone your age. There are many target-date funds you might refer to, but I'd suggest checking out the ones that made our MONEY 70 list of recommended funds. I'm not saying you've got to duplicate their asset blend exactly. But you can use it as a starting point and then adjust according to your own tastes.

Once you've arrived at a stocks-bonds mix that seems right for you, plug it into Morningstar's Asset Allocator tool. Doing that will show you how that allocation might do in the future. By using the tool's sliders, you can also fiddle with the mix and see how that affects risk and return.

As a final check, you might want to plug your portfolio, as well as such information as your 401(k) account balance and the percentage of salary you're saving each year, into T. Rowe Price's Retirement Income Calculator. This will show you whether you're on track to a secure retirement, given your savings effort and investing strategy. If the outlook is iffy, you can see how adjustments like saving more and investing differently improve your prospects.

What you don't want to do, though, is set your course by looking in the rear-view mirror. That wouldn't be a smart way to drive your car, and it makes just as little sense for investing your 401(k).

From The CNN Money published on September 21, 2010