The Dangers of Using Bonds as Collateral for Loans

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By Jacob Maslow

Buying bonds has long been considered a safe investment tool. A look at China’s fluctuating market is a prime example of when using Bonds as collateral for loans is a dangerous practice. Many investors in the Chinese market are borrowing money using Bonds as collateral, but this is causing an adverse side effect.

What investors are doing is using bonds as collateral to take out loans, and buying more bonds with the money. Debt issuance in the country is rising, and its yields are being pushed to multiyear lows as a result.

Effectively, investors are pushing down the value of these bonds and distorting the market as a result. The yields on these bonds are now almost at the same level as government bonds, which are a much safer investment option.

Another concern of analysts is that if bond prices pull back, it will cause many investors to sell their bonds to pay off their current loan requirements. What will happen is this will cause bond prices to fall even further. This is the exact same thing that occurred during the summer, and is bound to occur again in the coming months.

Under the current laws, borrowing is done through repurchase agreements or repos. Retail investors can now be involved in a repo, so institutional investors are the actual borrowers in the market. You have banks, security firms and wealth management managers by these bonds.

China saw a huge volume of bond repos occurring in the third quarter with a 13% increase. This is the highest volume from borrowing backed by bonds in the country and almost doubled since July to September of last year.

Most of this money, according to analysts, is investors using their bonds as collateral to buy more bonds. This is a never-ending cycle where the new bonds are used as collateral to buy even more bonds. Bond-backed borrowing is 2 ½ times higher than the entire bond market in the country.

The difference in yields between corporate bonds and government has lowered dramatically to just 1 percentage point. In 2014, the gap was 2 percentage points. Investors are at risk because there is no certainty that bond prices will not fall. If these prices were to fall, investors would be forced to sell their bonds, causing a further decline in the bond market.

This is the same exact thing that happened in the Shanghai Composite Index due to margin loans. These loans were used to buy stocks and accounted for 9% of the free float market. The composite is now down 36% and margin financing has dropped 58% in the process.

Using bonds as collateral for loans, especially in fluctuating markets, will devalue bonds in the long-term. While we’re using China as an example, this could happen in any country. Analyzing repo interest rate, data shows that the interest rate for seven-day repos is 2.5% compared to 5.07% just a year ago.

There is a risk when using Bonds as collateral for any loans. When these bonds have their value dropped dramatically, they will need to be sold, causing the market to suffer in the process. It’s a high risk maneuver that should not be used unless absolutely necessary.

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