(Bloomberg) -- A fizzing five-month rally in Chinese government bonds looks set to end this month, as the haven buying spree comes under threat from expectations of higher debt issuance in the second quarter and a weaker yuan.

The monthly return on Bloomberg’s gauge of the nation’s treasury bonds is essentially zero with just two trading days left in March. Coupon earnings — a gauge of interest income from the debt holdings — have fallen to a 17-year low of 0.2%, while capital gains turned negative for first month in five.

Traders are taking a closer look at their bond positioning after the rally on the back of China’s lackluster economic growth, dovish monetary policy and the impact of cash sloshing round the system with loan demand so weak. Extra stimulus to support the beleaguered property sector may trigger a shift toward riskier assets and Beijing’s plan to issue more government debt could put upward pressure on yields.

Renewed concern about a weak yuan has also spurred speculation the People’s Bank of China might further delay expected interest rate cuts to help stabilize the currency.

“The rate-cut possibility is low in the second quarter in our view and loose liquidity may normalize as government bond issuance picks up,” said Zhaopeng Xing, senior strategist at Australia & New Zealand Banking Group. “That will put some upward pressure on bond yields.”

Low Yields

Even if the impact from a potential supply shock turns out to be moderate, bond returns have become less alluring already. The scramble for fixed-income assets has sent benchmark sovereign yields to two-decade lows, while the extra premium investors get from longer-dated or high-grade corporate bonds is evaporating.

“The scope of returns doesn’t look promising. There’s almost no extra yield in term spreads or credit spreads with both very squeezed,” said Yang Hao, a fixed income analyst at Nanjing Securities. “Coupons are very low. and capital gains look uncertain if there’s no new buyers to buy bonds at lower yields.”

Investor views are currently split, according to Larry Hu, head of China Economics at Macquarie Securities Ltd. 

“Bears worry that things may have gone too far,” Hu wrote in a recent note. “Bulls, however, point to the lack of credit demand in the real economy, which will trap liquidity in the interbank market and create more demand for bonds.” 

Banks, sitting on extra cash that they are not able to lend, often buy bonds to earn a return.

Aggressive Pricing

Ten-year government bond yields of about 2.3% are around 20 basis points below those one-year policy loans. Some market participants interpret that as a sign that traders may have been too aggressive in pricing in more rate cuts from the PBOC. 

That gap means longer-dated bonds will be more vulnerable to a correction relative to their shorter-maturity peers, should there be any improvement in economic fundamentals, Yongbin Xu, director of rate strategy at U-shine Investment Group.

“If the economy improves, the curve might steepen with long-end yields heading up so there’s a lot of uncertainty,” Xu said. “I don’t find a good way to position.”

Meanwhile on the bond supply front, China’s Finance Ministry plans to issue a 1 trillion yuan ($138 billion) ultra-long special government security this year, with traders eyeing the second quarter as a possibility. That would quickly correct what has been a bond issuance shortfall in the first quarter. 

Separately, the Agricultural Development Bank of China, one of the biggest issuers in the nation’s onshore debt market, is mulling an increase in its bond sales in the coming quarter and an boost to the proportion of long-term notes in its issuance. 

JPMorgan Asset Management is confident about the ability of the market to absorb the extra debt and remains constructive on China bonds, Jason Pang, Asia FX & rates portfolio manager, told Bloomberg Television last week.

Still, “we might be in the last mile of the rally,” he said.

(Updates with debt issuance plan of China policy bank ADBC.)

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