China Is Sending an Ominous Message to Junk Bond Buyers

China just darkened the future for riskier corporate credit around the world.

The world’s second-biggest economy shocked markets this week by depreciating its currency by the most in two decades, with the goal of aligning the yuan more closely to the market rate. In response, the average price of dollar-denominated junk bonds plunged to its lowest level since 2011.

Debt of some energy companies, including Energy XXI Gulf Coast Inc. and Sandridge Energy Inc., fell more than 5 percent on Tuesday alone, Bank of America Merrill Lynch index data show. And China’s move deepened losses on obligations issued by U.S. metals and mining companies, which are already suffering their highest default rate since 2003.

Why is a cut in the yuan’s value such a huge deal for U.S. corporate credit? Because it indicates that China’s growth is slowing down, perhaps more than analysts expected, which directly affects industrial companies that rely on continual demand from the $10.4 trillion economy. The problem is particularly acute for commodity producers that have already been struggling to meet their bills in the face of lower natural-resources values.

China’s decision to effectively make its goods cheaper for the rest of the world to buy also makes it difficult for wages and consumer prices to increase globally. That undermines what central bankers around the world have been trying to accomplish over the past six years as they unleashed unprecedented policies of buying bonds and lowering benchmark rates.

‘Global Disinflation’

“The outlook for developed markets suddenly got a lot worse,” wrote Krishna Memani, chief investment officer at OppenheimerFunds, in an Aug. 11 report.

This is particularly concerning for businesses that are most reliant on developers to construct and fuel buildings, roads, schools and factories.

Debt issued by U.S. metals and mining companies had a 10 percent default rate at the latest reading, according to a Fitch Ratings. That $53 billion pool of obligations has already endured a 15.3 percent loss this year, Bank of America Merrill Lynch index data show.

Prices in the $1.3 trillion U.S. junk-bond market have fallen to an average 95.8 cents on the dollar from this year’s high of 101.3 cents in February, the data show.

Under Control?

The losses may deepen if China fails to keep a grip on how quickly its currency tumbles and the Federal Reserve decides to go ahead and raise U.S. benchmark rates this year, as they’ve been planning to do. That would probably lead to the dollar strengthening, bond yields rising and debt prices falling.

On the flip side, the depreciating Chinese currency could end up having a positive impact. It could stimulate growth in that economy and prompt the U.S. to delay its plans to tighten monetary policy, which would prolong the easy-money policies that have allowed speculative companies to sell record amounts of debt.

Since the move was announced, the yuan has led the biggest two-day slide in Asian currencies since 2008.

While the People’s Bank of China is following through on a pledge to align its currency more closely with the market rate, people familiar with the matter said authorities intervened to support the yuan and told banks to limit some companies’ dollar purchases.

“China’s move could be negative in the near-term,” said Jonathan Mackay, a senior market strategist at Morgan Stanley’s wealth-management unit, “if the market doesn’t believe they have it under control.”

So far, the market isn’t convinced about that.

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