Following the recent opening of China’s $7.3 trillion interbank bond market, the biggest flows are tipped to go into government and policy-bank bonds, but foreign investors are also itching to tap the $1.9 trillion credit segment for its higher yields.
Of course, corporate bonds come with commensurately higher risks, particularly in China. Hence fund managers – and mainland regulators – are sharpening their focus on mainland domestic ratings and credit risk, but this is easier said than done.
Comprising enterprise bonds, medium-term notes, corporate bonds, commercial paper and government supported corporate bonds, China’s credit segment is bigger than even the US’s $1.3 trillion high-yield market. Glaringly, foreign investors own less than 1% of it.
Chinese corporate credits yield 3.74% for AAA-rated and 4.84% for AA-rated, versus 2.52% for the weighted average six-and-a-half-year yield of the Barclays Global Aggregate Corporate Bond Index as of May 11.
However, there are two major obstacles: the absence of reliable credit ratings and a consequential risk of a surge in defaults, which were unknown in the mainland bond market until a few years ago. Consensus now suggests more are on the way, as they should be in a functional market.
Fixed income managers and rating agencies told AsianInvestor they expect more onshore issuers to miss payments as the economy stutters and the central government puts ‘zombie companies’ – loss-making firms with excess capacity – out of their misery.
The first known credit default in China – that of Chaori Solar Energy – came in March 2014. Investors witnessed eight in 2015, and a further seven in the first four months of this year. State-owned enterprises (SOEs) have also missed payments, including the likes of China Railway Materials Company, Sinosteel, China National Erzhong Group and Baoding Tianwei.
In other words, the days of the implicit government guarantee are gone.
The recent wave of defaults has caused a pullback in new issuance and a widening of spreads. According to Chinese media reports, 148 bond deals were cancelled or postponed in April due to weak demand, with many investors seeking a higher return for the risk they were taking.
The average yield for domestic AAA-rated and AA-rated corporate bonds with three-year duration has diverged, with the spread widening from 175 basis points as of May 12 from 70bp in October, according to state-owned settlement company Chinabond.
“The market has started to price in credit risk,” said Ivan Chung, associate managing director for Asia Pacific at Moody’s.
Yet investors are aware this is the only the start of the shakeout. Amid the widening of spreads, in the past six months, industry players have raised concerns over default risk in the $745 billion total of outstanding municipal or urban bonds issued by local government financing vehicles (LGFVs). It is a sudden realisation that these credits may no longer be guaranteed. The floor can fall away.
Whether LGFVs will be allowed to default depends on the central government’s attitude, but they do not appear to have implicit support, said Moody’s Chung. That would be similar to the situation for SOEs, where the central government’s attitude has changed in the past few years, as it opted to stop bailing them out, he added.
The immediate risk to foreign investors is not great, since they hold few onshore corporate and municipal bonds. Most are largely invested in onshore government bonds and policy-bank bonds rather than corporate credits.
Nonetheless, the spotlight has been turned onto the research capabilities of bond managers and the credibility of rating agencies.
Many foreign managers are boosting onshore credit research teams, or leveraging the capabilities of their joint ventures, with Singapore-based Fullerton one recent example.
But the fact remains that few investors have experienced credit defaults in this market. Already there have been painful lessons. A November default by Shandong Shanshui Cement on its short-term notes saw Shanghai-based Fullgoal Fund become the first mainland firm to take court action to protect its interests. Four money-market funds also suffered losses on their holdings in Shanshui commercial paper.
“The lessons are bigger for local fund managers than foreign ones, as we have always been cognisant of credit risk, from sovereign to corporate,” said Chia Woon Khien, senior fixed income portfolio manager at Japan's Nikko Asset Management.
Moody’s Chung added: “Now bond investors have to bear the risks of their own investment decisions. Credit ratings as a reference tool become more important amid this marketisation process."
Note: The full version of this article appeared in the May issue of AsianInvestor magazine.