As we delve into the dynamics of China's municipal bond market in 2024, a stark contrast becomes evidentOn one hand, the market grapples with persistent risks associated with non-standard municipal debts, while on the other, a robust surge in demand for standardized municipal bonds is witnessed, driven by a novel set of debt reduction policies that have catalyzed unprecedented levels of subscription and a constant drop in issuance rates.

Recent data from Zhongzheng Pengyuan shows that by the end of October 2024, the market had recorded a staggering 66 instances of non-standard debt risks.

Reflecting on the initial signs of trouble, one remembers the first-ever default of a non-standard municipal debt in January 2018, when China Rongzhi International Trust announced that a state-owned enterprise in Yunnan Province failed to repay its trust loan's principal and interest

This event marked a watershed moment, as it shattered faith in the rigid repayment belief of municipal financing platforms, leading to sporadic defaults in various provinces across China.

In response to rising default risks, the Political Bureau of the Central Committee laid out a plan in April 2024 to effectively address local government debt issues, focusing on regions with high debt risks to ensure that reductions in debt do not stymie developmental efforts.

Consequently, the risks associated with municipal debt payments are perceived to have been alleviated, with high-quality municipal bonds receiving enthusiastic attention from institutional investors.

In the early days of December 2024, amidst a backdrop of enthusiastic institutional buying and a scarcity of quality assets, high-grade municipal bonds traded vigorously in the secondary market, with yields plummeting

Notably, some AAA-rated municipal bonds saw their issuance rates drop below 2%.

Wang Fang, President of First Capital Securities, having closely observed the current state of the bond market, shared a thought-provoking insight: today’s bond market is facing an “asset shortage,” where high-yield bonds are becoming increasingly scarce.

Looking back at the bond market's performance since the beginning of 2024 reveals a series of noteworthy changesFirstly, market liquidity has remained relatively abundant, with a significant flow of capital in search of suitable investment opportunitiesThis has led to a marked downward trend in the yield of 10-year government bonds, continuously slipping below 2% and currently hovering around 1.6%. Such shifts in yield create a unique market landscape for banks, which find themselves in a state of “asset scarcity.”

The phenomenon of “asset scarcity” indicates that while banks hold a considerable amount of funds, they struggle to discover sufficient, high-quality assets that meet yield expectations for their investments

Nonetheless, banks face relatively lower pressure on the liability side, benefiting from the current liquidity scenario and the overarching financial environment.

As local governments aggressively pursue debt reduction, the landscape for municipal bonds has transformed intriguingly, revitalizing their status as desirable investment vehiclesPreviously, municipal bonds may have demonstrated varied performance due to numerous factorsHowever, with governments actively working on debt resolution, the associated risks have been largely mitigated, significantly enhancing market confidence and demand for municipal bondsInvestors are increasingly focusing on these assets as a key choice for bond investments, given that in an environment characterized by asset scarcity, the relative stability and backing of local governments make municipal bonds inherently attractive.

Yet, despite the indications of a potential economic rebound, with several economic indicators and market performances trending positively, investor sentiment regarding long-term economic prospects remains cautious

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This circumspective stance stems from the multifaceted nature of economic recovery, which is often a complex and protracted journeyWhile short-term advantages are apparent, persistent and stable growth remains uncertain, influenced by various unpredictable factors such as global economic fluctuations and domestic industrial structural adjustments.

The situation is equally challenging for industrial debtsThe issuers in this category, typically enterprises relying on bonds for financing, continue to grapple with significant operational pressuresA confluence of macroeconomic environments, intensifying industry competition, and rising costs poses various challenges to these companies, undermining their profitability and debt servicing abilitiesConsequently, restoring robust financing capabilities, particularly in terms of bond issuance, will likely demand considerable time and depend on several conditions, including broader economic stabilization and improvements in companies' operational circumstances.

As of now, there have been no defaults in the municipal bond sector, and the prevailing belief in municipal debt continues to hold sway within the market

Will this "faith in municipal bonds" endure into 2025? The general consensus leans towards a positive affirmation.

Looking ahead to 2025, CITIC Securities anticipates that under the principal narrative of debt replacement, the risks within the municipal bond market will remain manageableHowever, the supply of industrial debt is unlikely to reverse the prevailing asset scarcity pattern in the credit market, indicating that municipal bonds will continue to represent a core asset for credit allocationsThe ongoing decline in benchmark interest rates suggests that finding residual yield premiums in municipal bonds will emerge as a crucial competitive focal point.

Additionally, CITIC Securities notes that the current configuration dynamics of the municipal market are centered around the mid-2027 timeframe, where investors exhibit differing views regarding the cost-effectiveness of debt maturing beyond this point