GUOTAI Junan Securities Co, China's top corporate bond underwriter, is seeing demand for debt sold by companies linked to the nation's cities and provinces, after its own analysts warned one-in-three of these borrowers are bleeding cash.

Investors expect local governments to bail out the companies they use to finance roads, bridges and sewage networks, and ensure they don't default, according to Cheng Hao, the head of fixed-income at Beijing-based Guotai Junan. About one-third of those companies that have sold bonds in China's corporate bond market have negative cash flows based on their latest financial statements, Guotai Junan analysts wrote in a July 6 research note.

"There's no need to worry" about investor demand suffering, Cheng said in a phone interview on July 8. People are confident local governments backing these companies can "handle" any problems, he said.

China's five interest-rate increases since October have failed to curb inflation that last month reached the fastest since June 2008, as the nation's local authorities skirt borrowing restrictions by selling bonds through special purpose vehicles.

Auditor General Liu Jiayi said on June 27 that China's first assessment of local government bonds found liabilities of 10.7 trillion yuan (US$1.7 trillion) as of December 31. Of that, 8 billion yuan is overdue, and companies are too often relying on government land sales to meet repayments, his report said. As much as 30 percent of loans to local government entities may go bad, accounting for the biggest source of banks' non-performing assets, Standard & Poor's said in April.

The yield on Loudi City Construction Investment Group Co's 7.15 percent March 2019 debt, rated AA by Dagong Global Credit Ratings Co Ltd, the Beijing-based agency's third-highest investment grade, has risen 17 basis points, or 0.17 percentage point, since it first started trading in March to 7.26 percent on Monday, according to Chinabond data.

That compares with the 7.9 percent yield on debt due April 2024 of the United States city of Detroit, rated three levels below investment grade by Moody's Investors Service.

Guotai Junan, based in Beijing, is the No. 1 underwriter of yuan-denominated corporate bonds in China this year, with an 8.8 percent market share valued at 19.9 billion yuan, according to data compiled by Bloomberg. China International Capital Corp, the nation's largest investment bank, estimated in April sales of debt linked to local governments may reach 300 billion yuan in 2011, from 152 billion yuan last year.

'Hardly Make Ends Meet'

"Demand is there," said Cheng. Banks make up the majority of investors in the market for debt sold by so-called local government financing vehicles, he said.

While companies linked to local governments have never failed to make payments on their yuan bonds, Guangdong International Trust & Investment Corp defaulted in 1998 on foreign bonds denominated in dollars and registered for sale in the US known as "yankee notes," becoming the first Chinese issuer to do so since the People's Republic of China was formed in 1949. Local governments, banned from selling bonds directly, set up financing vehicles to fund projects designed to stimulate economic growth during the global financial crisis.

"Even without new investments in the next couple of years, they can hardly make ends meet," Guotai Junan analysts including Jiang Chao and Chen Lan wrote in the July 6 research note.

The likelihood companies linked to local authorities will default on their bonds, though, is "very small" as they enjoy close relationships with their banks that will allow them to restructure loans in the event of financial difficulty and makes it more likely bond investors are repaid first, Guotai Junan's analysts wrote in the report.

The extra yield investors demand to own bonds of Loudi City Construction instead of central government debt reached 345 basis points on July 8, the most since the notes were first sold in March and yielded 329 basis points more, Chinabond prices show.

Xinyu City Construction Investment & Development Co's 6.5 percent January 2018 debt yielded 285 basis points more than sovereign debt on July 8, the most since hitting a then record 283 on April 12, the data show.

China's Finance Ministry sold 23.9 billion yuan of bonds on Monday on behalf of 11 provinces and municipalities, falling short of a 25 billion yuan target, according to a trader who didn't want to be identified at a finance company required to bid at the auction. The notes were priced to yield 3.93 percent.

'Growing Concern'

"The primary reason for the auction failure is the cash shortage that limits demand for bonds," said Hu Hangyu, a Beijing-based bond analyst at Citic Securities Co, China's biggest listed brokerage. "It may also reflect investors' growing concern about local governments' financial strength."

Local governments should use proceeds from bond sales to help provide funding for the construction of low-cost housing, according to a statement on the Finance Ministry's website yesterday. Affordable housing should take priority over other projects in the use of funds, the statement said.

Premier Wen Jiabao aims to build 36 million low-cost homes by 2015, an initiative that will see 2 trillion yuan added to local government borrowing by 2012, bringing it to a total 12 trillion yuan, Standard Chartered Plc estimates.

Regional authorities' financial platforms will use corporate bonds to make up a shortfall of 200 to 300 billion yuan needed for affordable housing, driving them further into debt, China International Capital analysts led by Xu Xiaoqing in Beijing said in a June 24 report.

Default-Swaps Advance

"If they're allowing existing borrowers to issue bonds for new projects, there's going to be a strong temptation to use those proceeds to service existing debt," Patrick Chovanec, an associate professor at Tsinghua University's School of Economics and Management in Beijing, said in a phone interview.

The cost of five-year credit-default swaps insuring Chinese government bonds from default rose four basis points to 93 basis points on Monday, a one-year high, 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 protect investors from losses when a company or government fails to repay its debt.

The yuan weakened 0.03 percent to close at 6.4671 per dollar in Shanghai on Monday, according to the China Foreign Exchange Trade System. The currency touched 6.4599 on July 4, the strongest level against the dollar since 1993. In Hong Kong's offshore market, the yuan fell 0.1 percent to 6.4650 yesterday, the data show.

The yield on the benchmark one-year government bond fell 1 basis point to 3.32 percent in Shanghai on Monday, according to Chinabond prices. The benchmark seven-day repurchase rate, a measure of the availability of funds between local banks, fell 83 basis points to 5.32 percent, data compiled by Bloomberg show.