Pimco Favors Top-of-Pyramid Bonds as China Lets Zombies Default

  • `Look at who sits at the top of the pyramid,' says Mukherji
  • Morgan Stanley Investment prefers centrally controlled firms

As Premier Li Keqiang allows zombie companies to fail, bond funds are turning to debt of companies so important to China’s future that he would never pull support.

QuickTake China’s Debt Bomb

Pacific Investment Management Co. is favoring strong, investment-grade energy, utility, consumer and Internet companies. Both Pimco and Morgan Stanley Investment Management favor firms so strategic that they report directly to the central government rather than provincial authorities. Aberdeen Asset Management Plc and the U.S. funds are also focusing on which companies will survive as implicit state guarantees wane.

“For China state-owned enterprises, we need to look at who sits at the top of the pyramid,” said Raja Mukherji, Hong Kong-based head of Asian credit research at Pimco. “The key is to figure out which sectors will get state support and also generate positive return."

Surging debt amid China’s worst economic slowdown in a quarter-century prompted Moody’s Investors Service to cut its outlook on 38 state firms in March, while Fitch Ratings said this month more issuers will end up in restructuring rather than bailouts. Local junk notes are suffering the worst selloff since 2014 after three state-owned enterprises reneged on public bonds this year, compared to at least two for the whole of 2015.

"Go back 12-18 months and it was taboo to think that a state-owned entity would go bankrupt but it is clear now that the government is willing to allow this to happen," said Warren Mar, managing director of emerging market corporate debt at Morgan Stanley Investment. Provincially backed enterprises are the most vulnerable "should credit conditions tighten or market access for these names reduces," he said.

The discrimination between weak and strong issuers will only widen the gap in their fortunes. China Petroleum & Chemical Corp., which owns China’s largest oil refiner, raised $3 billion selling dollar debt this week and Moody’s said in a report it will benefit from its “very high strategic importance to China.”

By contrast, commodity trader China Railway Materials Co. halted bond trading on April 11, saying it’s studying “repayment issues.” Moody’s cut its rating on Yanzhou Coal Mining Co. two steps to junk last week. State-owned Dongbei Special Steel Group Co., Chinacoal Group Shanxi Huayu Energy Co. and transformer maker Baoding Tianwei Group Co. defaulted this month, prompting a wave of cancellations on domestic debt offerings.

Waning Guarantees

"The implicit government guarantee has been waning for weaker SOE credits and corporate sectors with a bleak earnings outlook will also be shunned,” said Edmund Goh, Kuala Lumpur-based investment manager at Aberdeen Asset.

The yield spread for AA- rated three-year Chinese local bonds surged 42 basis points, set for the worst monthly selloff since December 2014.

Morgan Stanley Investment doesn’t see Premier Li allowing defaults in parts of the credit market to trigger contagion.

"To what extent will the government in some way help out with the transition to the streamlining of the SOE sector?" said Mar. "It is going to be one of these processes that is going to develop over time and there will be a level of gradualism to it."

HSBC Holdings Plc wrote in an April 8 report that "support for troubled local SOEs is weakening" just as credit stress mounts in sectors with excess capacity. Firms in the metals, mining or coal industries must repay a record 240 billion yuan of notes in the second quarter, according to data compiled by Bloomberg.

“It’s hard to guess which SOE the government will bail out, so credit profile is the most important thing we look at,” said Qiu Xinhong, a money manager at First State Cinda Fund Management Co. “We avoid SOEs struggling with losses or overcapacity problems.”

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