China's Hot Bond Market Seen at Risk of Default Chain Reaction

  • Nation's credit-default swaps rise by record at start of year
  • China Securities says systemic risks may emerge in debt market

China’s bond investors are raking it in as an equity rout scatters cash into fixed-income securities. But concerns are rising that spreading defaults and a sliding yuan will spark a selloff.

Credit derivatives that are seen as a gauge of risk in the market have spiked 22 basis points since Dec. 31, the worst start to a year in data going back to 2008. The number of listed firms with debt double equity has jumped to 339 amid a weakening economy, from 185 in 2007. Traders surveyed by Bloomberg in December said note failures will spread.

“2016 is a year when we will see systemic risks emerge in China’s credit market,” said Ji Weijie, credit analyst in Beijing at China Securities Co., the top arranger of bond offerings from state-owned and listed firms. "There may be a chain reaction as more companies are likely to fail in a slowing economy and related firms could go down too."

The 18 percent tumble in China’s benchmark stock gauge this year has so far buoyed bonds, cutting yield premiums on local securities to record lows and on dollar debentures from the nation to the least in eight years. A reversal may be coming as the yuan’s slide spurs capital outflows that have forced the central bank to inject liquidity to hold down borrowing costs, a task it can’t manage indefinitely, according to First State Cinda Fund Management Co.

The weakest economic growth in a quarter century prompted onshore defaults to jump to at least seven in 2015 even as Premier Li Keqiang vowed to limit failures. Hua Chuang Securities Co. said investors should avoid buying notes for now as surging supply also adds to risks that the hot onshore market will cool.

Such concerns have yet to be reflected in prices. The extra yield on top-rated local corporate debentures due in five years over similar-maturity government notes dropped 3.4 basis points since the start of the year to 57.3 basis points, near a record low. The premium on dollar securities from China is at 274 basis points, near the least since 2007, a Bank of America Merrill Lynch index shows.

“The Chinese government wants to maintain a low domestic borrowing rate to support growth by injecting liquidity into the system,” said Ben Sy, the head of fixed income, currencies and commodities at the private banking arm of JPMorgan Chase & Co. in Hong Kong. “CDS, on the other hand, is a proxy for global investors’ sentiment toward China and it can be speculative in nature.”

The plunging bond yields are driven by risk aversion after the stock sell-off and investors are getting cautious about buying into the rally, according to China Merchants Bank Co.

Failures Mount

“Investors are wondering how much more bond prices will go up this year because they rallied a lot last year,” said Liu Dongliang, a senior analyst at the lender. “People are concerned about defaults after the slew of bond failures in 2015.”

Pig iron producer Sichuan Shengda Group Ltd. last month became the latest Chinese company to renege on local debt obligations. China Shanshui Cement Group Ltd. also defaulted on a 2 billion yuan ($303.6 million) local bond in November, and its main operating unit said last week it’s unlikely to repay securities due Jan. 21.

The stock slide has kept money flowing into debt despite the mounting failures. The yuan has fallen 1.3 percent against the dollar this year.

The central bank has been pumping money into the financial system to keep interest rates low as stocks fall and foreign exchange reserves plummet on capital outflows. That’s helped the overnight repurchase rate, a gauge of interbank funding availability, decline 18 basis points this year to 1.94 percent.

Yet yuan declines limit room for the People’s Bank of China to cut interest rates further, and that’s bad for bonds, according to a Jan. 11 report from Hua Chuang Securities. The brokerage expects local note issuance to pick up, which could raise borrowing costs.

Right now investors are concerned more about missing out on making money in bonds, than the risks of a reversal, according to Commerzbank AG.

"So if there is a turnaround in bond yields, a lot of people are in for losses," said Zhou Hao, Singapore-based senior economist at the bank.

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