Blowout in China Bank Basel III Yield Shows Bad Debt Concern

  • Spreads widen on Bank of China, ICBC additional tier 1 paper
  • ‘Credit risks in Chinese economy may continue to worsen:’ S&P

Forecasts for what would be the first decline in total profits at China’s biggest banks in 10 years are raising concern in the bond market that lenders will need state help to clean up mounting bad debts.

The yield premium for Industrial & Commercial Bank of China Ltd.’s 6 percent Additional Tier 1 securities, which count as capital under Basel III rules, has widened 35 basis points to 311 basis points from the year’s low on Aug. 16. That for Bank of China Ltd.’s 6.75 percent notes rose 29 basis points in the same period. The turn in sentiment came after earnings reports from the largest five lenders last month showed the smallest increase in trailing 12-month profits in at least a dozen years. Both lenders saw the spread on their senior notes, which would be safer in any recapitalization, change little over the period.

Falling interest rates and flagging economic growth are eroding Chinese banks’ profitability just as bad debts mount. ICBC’s net interest margin, the difference between the rates it garners on loans and its funding costs, dropped to 2.21 percent at the end of June, from 2.53 percent a year earlier. The Basel-based Bank for International Settlements said on Sunday that a warning indicator for the nation’s banking stress has risen to a record.

“Declining net interest margins could be one of the concerns investors have on Chinese banks,” said He Xuanlai, credit analyst at Commerzbank AG in Singapore. “Previously profitability was never a problem despite rising bad loans. Now profitability is under pressure, which limits their ability to generate capital internally.”

ICBC had positive earnings growth in the first half and the bank can’t comment on its profitability in the second half, said a Beijing-based spokesperson. A call to Bank of China’s media department in Beijing went unanswered.

Total profits for the top five Chinese lenders may decline 2 percent this year, snapping a rising streak in the past decade, according to analysts surveyed by Bloomberg. Lending in the world’s second-largest economy is becoming less effective in stimulating growth. The BIS report showed China’s credit-to-gross domestic product ratio is 30.1 percent above its long-term trend, higher than the 10 percent level that flags a possible crisis.

The government could provide liquidity to repair capital ratios at banks, which have to convert AT1 securities into equity below certain levels, according to S&P Global Ratings. In the last major debt cleanup in 1999, taxpayers protected creditors from losses by funding asset-management firms to buy soured debt at face value.

“Credit risks in the Chinese economy may continue to worsen, as indicated by still-significant credit growth amid China’s economic slowdown and rapidly rising credit losses,” S&P wrote in a Monday report. 

Read: China Banks Play Capital Raising Catch-Up as Bad Loans Soar

The spread widening may also reflect a flood of supply of similar securities at home and abroad. China Citic Bank Corp. last month announced plans to raise as much as 40 billion yuan ($6 billion) of convertible bonds. Since Aug. 1, European finance companies raised $14 billion in capital with bond sales marketed in Asia.

“The new supply could have led institutional investors to diversify their Additional Tier 1 holdings” out of Chinese securities that have relatively low yields, said Matthew Phan, banking analyst at CreditSights in London.

Yields on such securities from ICBC dropped to a record low of 3.7 percent last month, much lower than the 7 percent yield for UBS Group AG’s similarly rated notes.

“Chinese AT1 instruments are correcting a bit more than the market recently because they are too expensive versus global peers,” said Ben Sy, head of fixed income, currencies and commodities at the private banking arm of JPMorgan Chase & Co. in Hong Kong.

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