Investors may be eagerly eyeing the opportunities on offer in China’s newly opened $7.3 trillion interbank bond market, but they are also wary of the risks – which are accentuated by the absence of reliable credit ratings. Moves are afoot to address the problem, but they will take time.
Both foreign investors and China’s securities watchdog agree that the rating mechanism used by mainland agencies is problematic. Onshore credit ratings are overly homogeneous: they comprise just four notches, ranging from AAA to AA. By contrast, international agencies such as Moody’s and Standard & Poor’s have a scale with 22 ratings.
The reasons for this are historical. Until 2012 Chinese insurers could only invest in corporate bonds with domestic ratings of AA or above. That rule was then relaxed to allow investments into single A credits, but by then the narrow scale was in place.
A further issue is that Chinese agencies adopt a different rationale in their ratings. They tend to place more weight on an issuer’s capitalisation, while global agencies adopt “expected loss” or “probability of default”. Last year’s Shanshui default showed how the immature mainland system failed to reflect the true credit risk.
Leading domestic rating agency China Chengxin International (CCXI) downgraded Shanshui paper from AA+ to AA six weeks before the default was confirmed. Yet three months earlier S&P had already downgraded Shanshui’s overseas dollar bond-issuer rating from B– to CCC with a negative outlook, reflecting a high probability of default.
In other words, domestic rating agencies can’t offer a forward-looking view to domestic investors, who have been used to assuming implicit government support.
But Shanshui Cement is not alone. More than half (52%) of China’s corporate bonds are rated AAA by onshore agencies, according to Goldman Sachs, and an AA-rated issuer can default without warning, as China does not attribute high-yield/junk status to any bonds.
What’s more, fund managers say the process of recovery and debt restructuring lacks transparency. When it comes to restructuring debt after a default, some issuers do eventually pay the principal back in full to bondholders; others repay banks first and bondholders take a haircut. There is no scale of seniority in terms of debt repayment.
Moreover, recoveries are settled not through a transparent legal process, but by negotiation between issuers, local governments, banks and bondholders.
“We see different, and somewhat inconsistent, arrangements during credit events,” said Arthur Lau, head of Asia ex-Japan fixed income at PineBridge Investments, based in Hong Kong. “This highlights the uncertainty credit investors face when trying to price the risks and anticipate the potential recovery.”
The China Securities Regulatory Commission has acknowledged the problems and has been investigating since September. It issued warnings to six local rating agencies late in March, including the biggest three: CCXI, Dagong Global Rating and Lianhe Credit.
The CSRC also criticised rating agency practices, such as a lack of standardised criteria and procedures, insufficient due diligence on ratings, and a lack of either a review system for credits covered or reports to follow up rating changes.
The situation is not going to improve overnight, but at least it is out in the open – investors can’t say they haven't been warned.
Note: the full version of this article appeared in the May issue of AsianInvestor magazine.