What should investors make of China’s first corporate debt default?
At the start of last month, a small Shanghai-based solar equipment manufacturer, Chaori Solar, became the first Chinese company to fail to make a full interest repayment on an onshore bond.
The default underlines the fact that, among the hundreds of issuers in China’s recent corporate debt boom, there are some that investors should have avoided, says Richard Smith, senior credit manager at Aberdeen Asset Management in London.
It’s hardly news that China’s solar sector is in trouble. The $15 million default is dwarfed by the $541 million offshore bond default of Suntech – the world’s largest solar panel maker – a year before.
And many argue that the Chaori default represents a step towards a more developed corporate bond market in China.
It represented a long-term positive for the market since it “will instil greater discipline to price credit risk more effectively” and improve capital allocation, says rating agency Fitch.
By letting a smaller firm go to the wall – one that few investors expected it to bail out – Beijing has shown it is giving the market room to price risk more accurately and is reducing the moral hazard of guaranteed government bailouts.
Jan Dehn, co-head of research at UK fund house Ashmore, points to other evidence of Beijing’s commitment to liberalisation. “After last year’s nationwide debt audit, the Chinese government feels the government is strong enough to forge ahead with interest rate liberalisation,” he says.
A week after the Chaori default, on March 11, Chinese central bank governor Zhou Xiaochuan committed to full liberalisation of deposit rates within two years, the first time Beijing has specified a timescale.
Corporate high-yield bond defaults in Europe, the US and emerging markets sit between 0% and 5%, notes Dehn. Ultimately China’s default rates should reach similar levels and have a long way to go. So given that, before Chaori, corporate bond defaults in China stood at 0%, Dehn wonders: “Why panic now?”
One reason could be steadily weakening covenant protection. “Covenant quality [based on the cumulative average] for Asian issuers has been declining since early 2011,” said a recent report from rating agency Moody’s.
Figure 1 (below) shows how protection for investors in Chinese corporate bonds has declined steadily (a lower number designates a stronger covenant).
Asian bonds remain built with stronger covenants than their peers in both emerging and developed markets, as figure 2 (below) explains. And covenant strength and default risk are very different – the graph shows that the US has the weakest covenants of all markets.
But Asia is certainly not immune from the greater power that issuers are enjoying, as appetite for yield continues to drive investors into weaker bond structures.
And it will exacerbate the risk of sudden price moves if, against Dehn’s advice, investors do see reason to panic.