February 9, 2017 / 1:02 AM / 6 months ago

China's changing debt risks drive up bond futures volumes

4 Min Read

* China bond futures turnover quadrupled between Oct and Dec

* Beijing's deleveraging campaign boosts risk-hedging demand

* Speculative trades may help double bond futures trading this year

By Samuel Shen and John Ruwitch

SHANGHAI, Feb 9 (Reuters) - Trading volumes in China's typically sleepy bond futures market have exploded in recent months as investors seek to hedge the growing risks of rising interest rates and a volatile debt sector.

Turnover of five- and 10-year bond futures quadrupled between October and December last year, data from China's financial futures exchange showed, a massive spurt for a market that has attracted only modest attention since its opening three years ago.

Volumes also remained high in January, defying the traditional Lunar New Year lull, as Chinese investors sought to hedge their interest rate exposures and as speculators bet on rising bond yields.

"Investors are worried that market rates will trend higher. They're worried about deleveraging, higher inflation and the risk of further slides in bond prices. They need risk-hedging," Li Jie, an analyst at brokerage CITIC Futures, said.

China re-launched the bond futures market in September 2013, nearly two decades after a multi-billion-yuan trading scandal led to its closure in 1995.

Importantly, the market remains off limits to banks and insurers, the biggest holders of the Chinese bonds underlying the futures, which makes brokerages and fund managers the dominant players in bond futures trade.

Since their launch, trading in futures - contracts that allow investors to buy or sell a bond on a specified date at a predetermined price - remained small, with investors finding little need for hedging in a low interest rate environment.

That changed in October last year when Beijing signaled a shift toward tighter monetary policy, shaking markets out of their comfort zone and sending both bond yields and interest rate swaps higher.

Many of these risks are new for an economy that has long operated on the assumption that most local debt is effectively guaranteed by the state.

Since 2014, China has sought to reduce overall debt levels - almost three times the size of the economy - by allowing select defaults, encouraging securitisation and proposing a debt for equity swap regime for troubled corporates. It has also imposed several regulations to restrain capital flight and ward off massive currency declines.

The result has been a turn in the three-year bull run in bond markets with 10-year yields at roughly 3.5 percent, up 80 basis points from their October lows.

Bearish Bets

For some investors such as hedge fund manager Wang Feng, bond futures are a convenient means to express their bearish bets on bonds and to make money from higher volatility.

"In the past, the market was not deep, or liquid enough for us", said Wang, CEO of hedge fund house Alpha Squared Capital.

Wang's firm uses quantitative strategies to trade stocks, commodities and financial derivatives. He anticipates a doubling in bond futures trading turnover this year.

Combined monthly turnover in China's five- and 10-year treasury futures < CFTc1> doubled in November to 820 billion yuan ($119.13 billion) from the previous month, before doubling again in December to a record 1.77 trillion yuan.

Turnover remained high in January, totaling almost 1.2 trillion yuan.

For now, increasing volumes are enticing for those seeking more robust hedging options.

"We will participate more in bond futures trading if this market becomes more actively-traded ... and brings in more liquidity along the way," said Alpha Squared Capital's Wang, a former Wall Street trader. ($1 = 6.8829 Chinese yuan)

Editing by Vidya Ranganathan and Sam Holmes

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