(Yicai Global) Aug. 25 -- Trusts and asset managers under the control of Chinese banks as well as mutual fund managers are gobbling up high-quality bonds such as those issued by local government financing vehicles and tier-2 capital bonds as China's financial institutions look for ways to put the extra funds gained through the country’s sustained loosening of monetary policy to good use.

“There are few assets on the market that match funds' return requirements,” an investment manager at the asset management division of a leading trust told Yicai Global.

“Most funds aim to give their clients a return of 4.5 percent, but only AA+ rated LGFV bonds offer such yields and have controllable risks. And AAA-rated LGFV bonds are in high demand by funds that don’t need a return of over 4 percent, but must meet an investment entry threshold and shield against all risks,” he said

It is unlikely that the volume of such assets will suddenly increase, and banks don’t want to invest blindly with the extra funds they now have due to cuts in the reserve requirement ratio. So they are scrambling for high-value assets, he said.

LGFV-issued bonds are still the preferred choice of trusts and asset managers controlled by banks. But local governments’ income from the sale of land use rights, which is connected to the use of LGFVs, is still affected by concerns over risks in the property market, Yicai Global learned.

As a result, LGFV’s net financing amount slumped 57.3 percent, or CNY128.3 billion (USD18.7 billion), last month from June and 36.4 percent, or CNY54.6 billion (USD8 billion), from a year ago, according to data from financial information platform Wind.

As demand surges, bonds’ coupon rates are falling. The average yield from LGFV bonds was 3.48 percent this month, down from 4.03 percent in January, according to Wind.

Mutual funds, though, prefer interest rate bonds, tier-2 capital bonds and perpetual bonds over LGFV-bonds.

"I feel LGFV bonds have not outperformed other assets in terms of declines in credit spread,” a fund manager at a leading mutual fund firm told Yicai Global. “Tier-2 capital bonds of the same level and maturity period have thicker spreads and LGFV bonds' risks are rising as a whole.

"Therefore, there is no special reason to rush to buy LGFV bonds. From the perspective of the current structure of mutual fund holdings, the proportion of pure credit debts is falling with higher proportions of tier-2 capital funds, perpetual bonds and asset-backed securities," he added.

"In our view, interest rates may slide further in the current quarter on slowing economic growth and sustained monetary easing by the central bank," said Jeffrey Zhang, an emerging market strategist at Crédit Agricole CIB.

Zhang is bullish on short-end three-year government bonds. He believes there is a still quite a big space for bonds' yields to fall further, driven by the longer-than-expected easing cycle. Spreads between one-year and three-year government bonds have expanded to a four-year high.

Editors: Liao Shumin, Kim Taylor