MNI: China's Interest Bond Tax To Inject Yield Volatility

Beijing’s move to resume value-added tax collection on bond interest income is expected to drive yields down initially and increase coupon rates, triggering short-term market volatility before underlying fundamentals regain prominence, advisors told MNI, noting the tax could also reshape the market's investor base. 

Coupon rates are likely to rise by 5-10 basis points on new issues as investors seek to compensate for the new levy, which applies to bonds issued by government and financial institutions, an anonymous advisor estimated. It may also prompt a rush for existing tax-exempt bonds, pushing their yields further down, he noted.

The tax takes effect on Aug 8, with banks subject to a 6% VAT, while wealth and asset management products will incur a 3% rate.

Although yields may initially fall as investors accumulate existing bonds, they are likely to rise again due to higher rates on new issuance and a potential pickup in risk appetite, said Yuan Haixia, director at China Chengxin International Credit Rating, citing recent policy signals including the anticipated rollout of policy-based financial instruments, a crackdown on excessive competition, and improving stock market sentiment. (See MNI: Beijing Preps Policy-based Bonds Aimed At Infrastructure)

A sustained reversal in the broader downward yield trend, however, remains unlikely, Yuan acknowledged, citing the fading impact of exporters front-loading shipments in H2, marginal cooling in domestic consumption and fixed-asset investment in June, and the potential for a reserve requirement ratio or interest rate cut by the People’s Bank of China in September or October. 

The yield on the actively traded 10-year treasury bond rose 5.75bp in July to 1.7044% amid rising risk appetite, after fluctuating between 1.6% and 1.9% in H1. The curve has edged down slightly since the start of August, with the yield closing at 1.6900% on Thursday.

STRUCTURAL SHIFT

Yuan estimated the tax could boost government revenue by CNY20-41 billion annually based on 2024 data, offering more fiscal space.

Banks, facing an added CNY23 billion a year in tax costs, are expected to reduce purchases of newly issued government and financial bonds, shifting toward high-dividend equities, increased lending to high-quality firms, and greater capital provision to non-bank financial institutions, the advisor said. Over time, the tax change could reshape bond market investor composition, with mutual funds gaining a relative edge over banks, he added. 

A structural realignment could also help channel more capital toward consumption-driven sectors, argued Dong Ximiao, chief researcher at Merchants Union Consumer Finance. “Whether it could tame enthusiasm towards long-term sovereign bonds remains to be seen,” he added, citing a persistent shortage of investable assets elsewhere.

Dong said the original VAT exemption – introduced to boost participation and support bond market growth – may have achieved its goal, as China’s bond market is the second largest in the world.

Yuan said previous preferential tax treatment was no longer suited to current conditions, as government bond yields were not directly comparable to credit yields, limiting their effectiveness as a pricing benchmark in the broader market.

Retail investors remain largely unaffected by the policy shift, with purchases under CNY100,000 per month or CNY300,000 per quarter still exempt from VAT, shielding smaller participants from the impact of the new rules.