China's bond market has seen rapid growth in the last decade. However, a string of corporate bond defaults by state-owned enterprises (SOEs) in recent weeks has shaken investor confidence.
In November, Yongcheng Coal & Electricity (Yongcheng) missed a payment of Rmb1 billion ($152.3 million). The state-run coal miner blamed tight liquidity for the miss. Other state-backed companies that failed to meet repayments included chipmaker Tsinghua Unigroup and Brilliance Auto Group, the carmaker linked to Germany luxury vehicles BMW.
Prior to Yongcheng’s default, five SOEs had defaulted between January and October this year, close to levels seen in the previous two years, according to a Fitch Ratings report dated November 16.
Weaker SOEs in sectors with overcapacity or commercialised sectors face higher default risk due to a lower probability of receiving state support, the report said. Yongcheng is mainly involved in the commercialised coal and chemicals sector, it added. Nevertheless, on average, SOE default risk remains below that of privately-owned enterprises (POEs). Twenty POEs defaulted on their onshore bonds from January to October this year, affecting total principal of Rmb49.2 billion ($7.49 billion).
In the first three quarters of this year, Chinese defaults dropped 20% from the same period a year ago to Rmb85.1 billion ($13 billion), according to Bloomberg-compiled data, but this is largely due to pandemic-related government-backed measures in the first half. These measures included delayed payments, swapping bonds or cancelling early repayment.
In December 2019, commodities trader Tewoo Group, restructured $1.25 billion of debt in which most investors saw heavy losses, marking it the biggest dollar-bond default among state-owned companies in two decades.
AsianInvestor asked experts how latest series of bond defaults in China properly will reflect the potentially arbitrary risks of investing in Chinese local debt.
The following comments have been edited for clarity and brevity
Alvin Ying, chief investment officer
BOC Group Life Insurance
I'm sure there are US high-yield corporates defaulting as well. However, we don't pay as much attention to individual defaulted names. We would normally ask our fund managers to focus on the big macro picture and at the same time do more thorough due diligence with each credit position.
With China, some [participants] always think that this might be the Minsky moment — that one little default that will trigger some kind of wave. You don't hear that as much about US corporates — it’s more China-specific.
Inherently some investors or committee members are already skeptical about China’s systematic soundness. And that's why, with every little headline, they would ask, 'is this the headline that would trigger a big Lehman event in China leading to a wave of default?'
Judy Kwok-cheung, fixed income research analyst
Bank of Singapore
The recent rounds of Chinese corporate bond defaults came from wide-ranging sectors. However, the total amount has not been as alarming. As compared to the 2019 financial year, default rates are still low.
Excluding central, regional, local governments and financial institution bonds, the default rate for corporate onshore bond market is under 0.4%.
What is unexpected is that provincial level SOEs are also defaulting. However, these developments allow the Chinese onshore bond market to become more mature as investors become more familiar with defaults. The important questions that needed to be answered include how long will the process take through the courts; what are the restructure packages, if any; and what are the recovery rates?
Through careful analysis and selection of credit names, Chinese corporate bonds, both onshore and offshore, still provide value, especially when the market indiscriminately penalises SOEs bonds. The recent negative sentiment has affected Chinese property bonds, which are more transparent in providing timely information and have more stable fundamentals. This sector will continue to do well into 2021. On the positive side, Chinese top leaders, in recent days, have indicated their intention to contain systemic risks, in particularly in SOEs bonds.
The market should reduce their expectations for any outright capital injections. The Chinese government has been supporting SOEs in the form of encouraging banks to support certain SOE issuers, and/or introducing new investors.
Neeraj Seth, head of Asian credit
The expected default rate is probably lower in China than in other areas such as the US, Europe and the broader emerging markets. Therefore, we believe China credit will remain very attractive in 2021.
Developed market bonds are increasingly insufficient to address investor need for income and yield, and we believe a shift in global portfolio allocations may reflect China’s optimal position to help address the unmet needs.
The latest series of defaults seen in China is an integral part of the credit cycle, not a systemic risk, and it’s important for investors to understand and manage the defaults accordingly. The defaults rate in the onshore market is of similar level to that of 2019, and we don’t think the default rates are going to be significantly higher in 2021.
There are two aspects around defaults in China we wish to highlight – first, we see a shift of focus on deleveraging from the financial sector in 2016-2017 to the SOE sector, which is a positive sign.
Second, we see a tightening of revenue for some of the provinces due to policy towards the real estate sector. Even though we do expect to see more defaults going into 2021, they will lead to some dislocations and better pricing of credit risk, providing investors with investment opportunities rather than downside risks.
Alan Siow, fixed income portfolio manager
All healthy credit markets must have defaults at some point in the cycle – it is a painful but necessary mechanism for the healthy functioning of the market. For some years now, Chinese regulators have been very conscious of the potential high degree of leverage in the corporate sector and we remain very much in the midst of an onshore deleveraging cycle that has only been temporarily interrupted by the Covid-19 epidemic.
We continue to view the broader Chinese fixed income markets as offering value for investors who are discerning and prepared to do their homework. We see the recent default cases as opportunities to use the dislocation in the markets to invest in good companies at attractive valuations.
This renewed focus has given rise to several new policies (including the “Three Red Lines”, designed to curb excesses specifically property sector), which have led to a de-facto tightening of financial conditions through the market. This tightening of financial condition as the economy begins to recover from the pandemic has led to isolated cases of distress, typically in companies which were already facing cash flow difficulties.
Some investors may choose to overlook these issues by taking comfort in the strength of implicit ties to government or to stronger parent or sibling companies – this is an approach that can be fraught with risk as the recent defaults have shown.