Chinese companies suspected of buying their own bonds

Chinese companies use a tactic where bond issuers are indirectly buying their own bond offerings, according to Bloomberg. The idea is to inflate issuance sizes, creating the image of greater access to capital than might otherwise be true, and leading to lower coupons in subsequent sales.

Market players began picking up on the practice, known as structured issuance when the deleveraging drive intensified a couple of years back.

The practice is one of several strategies for debtors to enhance their appeal to creditors, including one where borrowers guarantee each others’ debt. Use of stock as collateral for loans has also sown the seeds for volatility in stocks.

Lower rated private companies and local government financing vehicles, or LGFVs, have been the main users of structured issuance. One popular method is for the borrower to put up the money for the subordinated tranche — the first to absorb losses — of the asset-management vehicle that buys the bonds. As result, it exposes buyers of the senior tranche to greater risk in case of default.

Companies are likely to find continuing pressures when it comes to financing in 2019. S&P Global Ratings said this week that corporate defaults “will continue to increase modestly,” while debt servicing is set to become more difficult. Last year, local bond defaults hit a record high of 119.6 billion ($17.6 billion) yuan.

China’s policy makers have taken steps to support the flow of credit both to private companies and local authorities in recent months in an effort to arrest an economic slowdown. At the same time, the central bank has repeatedly said it won’t embrace a flood of liquidity, suggesting some borrowers will continue to battle for funding, and may be tempted by the structured-issuance route.

Structured issuance is likely to increase default risks, and institutions serving as conduits will also be likely to face potential losses.