China funds learn painful lessons from defaults

As the fallout from last month's Shanshui Cement default continues, mainland asset managers are being urged to strengthen their credit analysis capabilities.
China funds learn painful lessons from defaults

Chinese fund managers are learning painful lessons from the rising incidence of local bond defaults and should put in place credit analysis capabilities or boost their existing teams, say market participants. 

At least five mutual funds were affected by the Shanshui Cement default in November, while Shanghai-based Fullgoal has became the first Chinese fund house to sue an issuer to protect its interests.

Jeffrey Qi, portfolio manager at E Fund (HK), said: “The Shanshui default event has indicated the rising importance of credit analysis.” Investors have not paid much attention to this area, as credit defaults have so far been rare in the onshore bond market, he added. 

Chinese asset managers should ensure they have in-house credit analysis capabilities, especially as private bond issuers are often not covered by rating agencies, said a Shanghai-based fixed income specialist at a private fund firm. He expects to see more corporate defaults in 2016, and suggests mainland asset managers should be more focus on fixed income analysis as a whole.

Fullgoal filed its court action in Shanghai on December 8, suing Shanshui’s failure to pay principal and interest on short-term commercial paper (CP) issued by subsidiary Shandong Shanshui.

One of Fullgoal’s mutual funds – the new return dynamic allocation balanced fund – had invested in Shanshui CP named “15 Shanshui SCP001”. The fund house bought Rmb191 million of the Rmb2 billion in interbank short-term notes issued on April 14 and due to mature on November 12. This made it the fund in question’s top holding, with 9.09% of its total allocation as of September.

Shanshui’s CP default triggered a cross-default of the other CP issues and financial obligations issued by Shanshui in the onshore market and its dollar bonds in offshore market. This was the sixth credit default in China’s onshore bond market this year, but it marked the first default in the CP market, which was started by the central bank in 2005. 

CP issues are short-term unsecured notes, typically shorter than one year in duration. Total volume stood at Rmb2.3 trillion as of September, representing 5% of the Rmb44 trillion onshore bond market, according to rating agency Moody’s.

In addition to Fullgoal, four money market funds – managed by CCB-Principal Asset Management, Lion Fund Management and Xinyuan Asset Management – also invested in Shanshui CP, for a total of about Rmb200 million.

E Fund Management (HK), the overseas arm of China’s E Fund, said its New York-listed CP exchange-traded fund and its other fixed income products sold their holdings of Shanshui notes in June, ahead of the warning by rating agencies.

Standard & Poor’s downgraded Shanshui’s overseas dollar bond rating to from B- to CCC with a negative outlook on June 17. But domestic rating agency China Cheng Xin International onlystarted downgrading Shanshui’s issuer rating in mid-September.

The first credit default in China – that of Chaori Solar Energy – only happened in March last year, but bond investors have since seen a total of eight defaults on the mainland this year. 

While many investors have so far been repaid their interest and principal following such events, the Shanshui case suggests they may have to learn how to protect their interests better. Investors face major risks in the debt recovery process as Shandong Shanshui has entered a process of liquidation.   

Rating agencies do not cite default rates for the onshore mainland corporate bond market, but Moody’s said the offshore high-yield default rate of for Chinese non-financial corporates was 6.7% in September, up from 5.1% at the end of 2014. The agency expects more defaults due to China’s slowing economic growth although rate-cutting by the central bank would help to mitigate this.

Foreign players such as JP Morgan Asset Management say more bond defaults will result in more efficient pricing in the immature bond market, to help segregate weaker corporates from the more robust ones. 

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