China Defaults Seen in Private Bonds as Real Yields Surge

A forklift maker, a leather producer and a textiles company have missed payments on privately sold bonds in China this year, as the central bank’s failure to cut borrowing costs in line with slowing inflation wrecks profits.

HSBC Holdings Plc says more defaults may occur after consumer price increases in the world’s second-biggest economy cooled to 0.8 percent in January, the slowest since 2009. Rates on the benchmark one-year lending rate after accounting for living costs rose to a five-year high at 4.59 percent. Prices received by manufacturers dropped 4.3 percent last month, matching January’s decline that was the biggest since 2009, according to a Bloomberg survey before data due tomorrow.

The People’s Bank of China’s two interest-rate cuts in three months have failed to lower borrowing costs for small- and medium-sized enterprises, which account for 70 percent of economic output. While larger state enterprises can rely on government bank loans, private-bond market delinquencies have prompted authorities to ban individuals from buying such notes, backtracking from a goal of expanding the market set up in 2012.

“One thing that worries me is falling inflation, which raises the real value of debt,” said John Zhu, Hong Kong-based economist at HSBC. “China’s producer price index, an indication of selling prices for goods produced by many SMEs, has been in negative territory for over three years. As a result, profits of those companies have fallen sharply and therefore more failures may occur.”

Investor Angst

Government data showed imports slid a more-than-estimated 20.5 percent in February from a year earlier, capping a fourth straight month of contraction and signaling weakness in domestic demand. Exports rose 48 percent.

While Premier Li Keqiang said last week China must “nurture a culture of entrepreneurship,” high real funding costs add to challenges for small firms as the economy cools.

Suqian Chief Leather Co., based in Jiangsu province, said it wouldn’t be able to pay noteholders who exercised a Feb. 5 sell option, people familiar with the matter said.

NBO Machinery Equipment Co., a forklift maker based in the eastern province of Anhui, faced difficulty paying principal and interest on a bond that could be sold back on Feb. 4, China Business News reported, citing underwriter Capital Securities Corp. NBO may fail to pay another security puttable on April 3, it said. A person who answered the phone at Capital Securities declined to transfer the call to someone in a position to comment. Two calls to NBO went unanswered.

Failures Forecast

Dongfei Mazuoli Textile Machinery Co., also based in Jiangsu, couldn’t pay principal and interest on securities as of Jan. 25, according to a Jan. 27 report on Tencent Holdings Ltd.’s A person in the company’s finance department declined to comment.

“We expect more defaults in China’s private bond market this year as many issuers, mostly small and medium enterprises, are facing a liquidity crunch,” said Ivan Chung, a senior vice president at Moody’s Investors Service in Hong Kong. “Compared to 2012, when the private bond market was established, refinancing conditions for those borrowers are now tougher as investors become more aware of the risks.”

The average yield for private notes in China is 9.21 percent, according to UBS Group AG.

Yields Rise

Borrowing costs have also jumped for lower-rated companies in the public bond market, as the slowest economic growth in more than two decades dents sentiment. The yield on five-year corporate debentures with ratings of AA- has surged 45 basis points to 5.93 percent since November, when the PBOC first cut interest rates. That contrasts with a 10-basis-point decrease for AAA bonds, which the nation’s biggest companies use to raise funds, with the same maturity to 4.42 percent.

“More risk is likely to emerge this year as a big number of bonds are maturing,” Moody’s Chung said. “For the companies that barely managed to pay coupons in the past couple of years, it will be much harder to pay the principal.”

China started a private junk bond market in 2012 to give small companies a way to raise funds outside of the so-called shadow banking system. Borrowers sell notes directly to institutional investors instead of public auctions.

The central bank cut the benchmark lending rate a quarter percentage point on Feb. 28, the second reduction in 14 weeks. That hasn’t translated into easier financing as the one-year interest rate swap jumped 23 basis points last week to 3.62 percent, the most this year, and was at 3.64 percent today.

Bloomberg’s China Monetary Conditions Index -- a weighted average of loan growth, real interest rates and China’s real effective exchange rate –- has fallen to 60.24, the lowest since the index started in 2003, signaling tighter conditions. A record jump in foreign-currency deposits in China reflects mounting expectations that the yuan will weaken further, according to Barclays Plc. The currency has fallen 0.94 percent against the dollar this year as capital outflows complicate efforts to bring down borrowing costs.

“Private companies are still having a disadvantage in getting funding,” said Ying Wang, senior director at Fitch Ratings in Shanghai. “State-owned enterprises are still the biggest beneficiaries of the increased liquidity.”

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