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China Bond Defaults Work Wonders to Spur Pricing for Risk

Updated on
  • Coal companies’ premiums to borrow rise versus peers
  • ‘This is what we have been hoping for,’ investor says

Just as global investors get a new channel to access China’s $9.8 trillion onshore bond market, it’s starting to look like one that they might recognize.

Gone are the days when China’s corporate debt was all pretty much priced the same, with an implicit government backstop giving buyers little reason to demand higher returns from some borrowers over others. Things started changing in 2014, when the Communist Party leadership with little warning began to allow defaults. With a steady rise in delinquencies, investors are now distinguishing among issuers based on perceived credit quality.

“We’re going much more to a proper market pricing,” said Sean Taylor, chief investment officer for the Asia Pacific region at Deutsche Asset Management in Hong Kong. “What we have now is a lot more differentiation and there’s more opportunities to make money.”

That’s good news for anyone contemplating the new Bond Connect, which started Monday and lets investors buy Chinese bonds through Hong Kong rather than have to register on the mainland. And it puts pressure on China’s bond-rating industry, which now faces full-bore foreign competition for the first time, to step up its own differentiation efforts.

Looking at corporate bonds with similar ratings among different business sectors, the group with the highest rates paid about 30 basis points more than peers borrowing at the cheapest rates back in late 2014. Now, the sector paying the highest to borrow has to shell out an average of about 2 percentage points over the strongest group, according to data compiled by Bloomberg.

Take China’s coal and real-estate sectors, which years ago had about a quarter percentage point gap in debt costs. Now, companies in the coal industry -- which has been hammered by the government’s focus on reducing excess capacity and battling pollution -- nowadays have average coupons on their bonds of about 1.5 percentage points more than those in property, where business is still strong.

A similar pattern is happening among local government financing vehicles, which exploded in number when provincial and municipal authorities started ramping up development spending during the global crisis late last decade. With national policy makers pressing local governments to make clear that LGFV debt doesn’t have official backing, bond buyers are starting to discriminate. 

For example, LGFVs in Tianjin, a metropolis east of Beijing that’s seen a construction boom over the past decade, now pay about 2.4 percentage point more than counterparts in capital Beijing. That’s up from about 30 basis points five years ago, Bloomberg-compiled data show.

“China isn’t one economy -- it’s 30 provinces plus and those different provinces have different fiscal positions, different levels of risk,” said Marc Franklin, a fund manager in Hong Kong for the Asian unit of Conning Holdings Ltd. Those provinces centered on industries that are under particular pressure -- whether it’s metals and mining or energy or coal -- will have a different credit profile to others, he said.

The powerful motivator behind this new trend: defaults. Since the first onshore default in 2014, the number has grown to 29 in 2016 and 14 so far in 2017. Policy makers have come to accept the concept as they grapple with reining in growth in leverage and try to give market dynamics a greater role in credit allocation. Even so, much credit is still distributed by the state-owned sector.

“The market is only just beginning to open up -- China is very new so of course it’s going to take a while for the market to mature and for people to differentiate between different credit grades, between different industries, between different maturities,” Bill Maldonado, Hong Kong-based global chief investment officer at HSBC Global Asset Management.

When it comes to bond ratings, further differentiation may be coming. As the government deepens cuts on excess capacity in old-economy industries, some of the AAA rated companies will likely be downgraded, according to Gang Meng, head of ratings at Golden Credit Rating International Co.

Golden Credit will soon be getting competition, now that foreign ratings agencies have been allowed full ownership of Chinese operations. The Bond Connect is also another way authorities are aiming to bring in overseas expertise to help develop pricing in a market that’s been dominated by domestic banks rather than fund managers.

“There is still a long way to go,” Angus Hui, a Hong Kong-based Asian fixed-income fund manager at Schroder Investment Management Ltd., said in a press conference. “Given the mentality now there is going to be defaults, and companies may not pay investors back 100 percent, a lot of the investors are getting more cautious. This is what we have been hoping for a very long period of time.”

— With assistance by Lianting Tu, Kana Nishizawa, Yuling Yang, and Allen Yan

(Updates with analyst comment in 11th paragraph.)
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