Special bonds may shrink bond-IRS arbitrage window

A planned issue of 1.55 trillion yuan ($204 billion) in special bonds may lift government bond yields more than interest rate swaps in months ahead, narrowing a spread that now offers traders an arbitrage opportunity.
Traders say the spread largely reflects the difference in liquidity where the local interest rate swap (IRS) market is influenced by the offshore yuan IRS market while the government debt market acts mostly in isolation from offshore trading.
This spread is set to shrink or even disappear as a massive new bond supply at the medium and long end is likely to steepen the bond yield curve more than that for the IRS, which mainly reflects bets on future interest rates, they say. Both the IRS and bond markets have now discounted possible hikes in benchmark interest rates of about 0.4 percentage point in the near term.
"The IRS/bond spread may be volatile, but it should gradually shrink as the special bond issue may push up longer-term bond yields by 20 basis points at least through next month," said a trader at a US bank in Shanghai. But investors can lock in gains now via a two-step trade.
In the first step, a 10-year government bond is sold and the proceeds of the sale are lent out to receive the seven-day floating bond repurchase rate. The second step is an interest rate swap, which pays the floating seven-day repo in return for the fixed 10-year IRS rate, traders said.
The two repo deals cancel each other out, eliminating exposure to China's notoriously volatile repo market and earning the bank the additional IRS/bond spread. In few weeks this opportunity may be lost, unless inflation jumps to a level beyond the market's expectations - perhaps 4.0 percent or more, and IRS curve steepens again as a result. The Ministry of Finance last week announced plans to issue special bonds with a maturity of at least 10 years to fund China's new overseas investment agency.
Media reports on Thursday said the sale of the first 500 billion yuan would kick off soon. The issuance will boost the central bank's holdings of bonds, and state media have said the central bank could sell all the additional bonds in the market by the end of October. This is expected to weigh on bond prices, particularly for maturities of five to 10 years, and drive yields higher as bond market players trim their holdings in preparation for the special bond issuance.
The 10-year IRS/bond spread narrowed to 36 bps on Wednesday, its narrowest in seven weeks, compared with 80 bps in early June, its widest in at least nine months. The spread has room to narrow further, considering that it traded in a range between 10 and 35 bps in the first quarter of this year and was as low as 2 bps last September, traders said.
"I find the Chinese supply situation reminiscent of the Korean situation," said a trader at a European bank in Shanghai, noting the huge supply of bonds in China, from both the government and the planned investment fund. "With IRS continued to be offered, would the IRS yield dip below bond yield? I think it may be possible," he said. In South Korea, government bond yields have mostly exceeded IRS rates since the end of 2005 because of the country's large bond supply.