China Inc.'s Next Debt Headache Is $580 Billion of Put Options Coming Due

  • Surge in yields means some 82% of such notes ‘in the money’
  • China has already seen a default after puts were exercised

Chinese companies battling to cope with the government-induced tightening in funding markets are bracing themselves for the next shoe to fall: a wave of early bond redemptions.

The nation’s businesses sold about 65 percent of all corporate bonds with put options worldwide, at 3.9 trillion yuan ($580 billion). Creditors holding some 2 trillion yuan of mainland notes will be able to exercise those options in the next two years, forcing issuers to either increase interest payments or redeem the debt early. Bonds sold by property companies are most affected, accounting for about a quarter of the 2 trillion yuan pile.

Chinese authorities’ efforts to cut excessive and speculative borrowing have helped drive up costs across the corporate bond market, the world’s largest outside the U.S., with yields on top-rated notes rising 144 basis points in the past year. It’s also meant the overwhelming majority of puttable bonds are now ripe for exercising, adding to concerns expressed by ratings companies that the strain on cash flows will lead to more missed payments.

“Right now liquidity conditions are relatively tight and financing costs have been high,” said Christopher Lee, managing director of corporate ratings at S&P Global Ratings, in an interview. “The financing environment is not very conducive for issuers and they may face refinancing pressure, even defaults.”

Some 82 percent of Chinese bonds with these options are now “in the money,” after yields climbed since late 2016, according to a Fitch Ratings Inc. report from June 28. That means investors have an incentive to put the bonds back to the company or ask for higher coupons to match the changed interest-rate environment. The peak of put redemption will come in 2019, with 1.4 trillion of bonds with those options becoming exercisable, according to data compiled by Bloomberg.

“From mid-2018, many companies will face the problem of puts becoming exercisable,” said Huang Weiping, senior analyst at Industrial Securities Co. in Shanghai. “About 80 percent of investors will likely want to put the bonds back to the company and get cash back into their pockets.”

Companies sold bonds at much lower rates in 2015 and 2016 than the current rates, so they will be forced to honor the put options, according to Deng Rui, chief investment officer for fixed income at Changjiang Securities Co. in Beijing.

His fund exercised the put option on one bond in April and Deng plans to do the same on several other bonds in the near future. All of those debentures were sold in 2015.

Liquidity pressure from put clauses has already spurred some casualties in China. Xinyang City Hongchang Pipe and Gas Project couldn’t fully repay investors when they exercised options on June 20. It was deemed a default by China International Capital Corp. State-owned Sinosteel Corp. had asked investors not to put the bonds after the option became exercisable on Oct. 20, 2015.

“We do not expect puttable bonds to cause systemic stress, but some companies could face difficulties if liquidity tightens further,” Fitch said in the June report.

Hiking Coupons

For issuers, one way to pre-empt liquidity pressures is to offer higher interest rates. China Evergrande Group hiked the coupon rate by 100 basis points on 6.8 billion yuan of notes sold in 2015, starting on the date when the put option on the securities became exercisable. As a result, creditors decided to demand redemption on less than 1 percent of the bonds.

Investors will be keeping a keen eye on conditions in China for the coming year, with data compiled by Bloomberg showing the peak in property bond put dates coming in 2018 and 2019. Investors may respond to any easing in liquidity stress by deciding against putting back their bonds, S&P’s Lee said. Conditions have improved recently, with 10-year government bond yields falling six basis points from a two-year high reached in May to stand at 3.63 percent.

Some holders are seeking opportunities to get rid of property bonds amid regulatory tightening in the sector, so developers face particularly high pressure for early redemptions, according to Deng at Changjiang Securities.

“Isolated problems cannot be ruled out, with companies that are heavily reliant on puttable bonds being likely to face pressure in the event of a significant tightening of liquidity conditions,” Fitch said in the June report.

— With assistance by Jing Zhao, Lianting Tu, and Vicky Wei

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