Record Downgrades Foreshadow First Onshore Default
China’s rating firms cut the most bond issuer rankings on record in June and brokerages said they are preparing for the onshore market’s first default as the world’s second-biggest economy slows.
A total of 38 issuers were downgraded last month, according to Guotai Junan Securities Co., the most since the nation’s third-biggest brokerage started compiling the data in 2005. Some 86 firms were upgraded, down from 88 a year earlier. China Chengxin Securities Rating Co. lowered Zhuhai Zhongfu Enterprise Co. (000659)’s debt rating to AA- from AA on June 28, causing the yield on the beverage package maker’s May 2015 bonds to almost triple to 15.01 percent.
“The government can’t save everyone,” said Xu Hanfei, a bond analyst in Shanghai at Guotai Junan. “In the future, downgrades may spread to high-grade bonds, especially those which rely heavily on support from the central or local governments.”
Premier Li Keqiang said July 16 that China shouldn’t change policy direction because of short-term changes in economic indicators, signaling he is ready to tolerate slower growth to rebalance investment away from industries with excessive capacity or which cause pollution. Economic expansion slumped to 7.5 percent in the second quarter, extending the longest streak of sub-8 percent growth in at least two decades.
The yield on one-year AA-rate bonds gained 28 basis points this week to 5.24 percent yesterday, according to data compiled by ChinaBond. The rate on similar-maturity AAA debt has risen 20 basis points to 4.76 percent. The gap between them was 48, the biggest since Feb. 3.
There have been no defaults in the publicly-traded domestic debt market since the central bank started regulating it in 1997, according to Moody’s Investors Service. Haitong Securities Co., the second-biggest listed brokerage, forecast yesterday that the first onshore default may occur in six to 12 months as the government seeks to build a sound credit system.
Concerns have mounted since the biggest unit of Suntech Power Holdings Co. (STP) went into bankruptcy in March after defaulting on $541 million of offshore bonds. The next month, LDK Solar Co. (LDK) failed to fully repay $23.8 million in dollar-denominated securities.
“Investors should no longer blindly invest in state-owned companies with overcapacities without good credit analysis,” said Jiang Chao, a bond analyst in Shanghai at Haitong Securities. “China can’t restructure the economy without a bond default.”
More downgrades may follow and help build China’s junk bond market, said Jiang, adding that an AA- rating in the nation is equivalent to non-investment grades overseas.
Most downgrades occurred in steel, chemicals and new energy last month, according to data compiled by Guotai Junan. These industries are facing overcapacity, falling earnings and high liability-to-asset ratios, according to the brokerage’s report released on July 8.
The rate on Anyang Iron & Steel Co.’s debt due February 2019 has risen 243 basis points to 9.31 percent as of 11:38 a.m. in Shanghai since China Chengxin Securities Rating Co. cut the state-owned company’s rating to AA- from AA on June 28, according to exchange data. The yield on Huayi Electric Co.’s bonds due November 2016 is up 152 basis points at 8.41 percent since Pengyuan Credit Rating Co. lowered the power equipment maker to AA- from AA on June 28.
“It’s hard to tell whether the deterioration will spread to other industries, and we can’t tell when the first default will come,” said Sun Zhipeng, a bond analyst at Orient Securities Co. in Shanghai. “But the massive downgrades will certainly have an impact on the secondary market. Investors are turning cautious on lower-grade bonds.”
China companies accounted for eight of the 10 financially weakest issuers of dollar-denominated notes in Asia outside of Japan, according to a July 5 Standard Chartered Plc report.
Borrowers from the nation have the equivalent of $112 billion of all types of bonds maturing this month, the most since April 2011, according to data compiled by Bloomberg. Another $110 billion of notes sold by Chinese borrowers are due by the end of August, data compiled by Bloomberg show.
Guotai Junan’s Xu said investors should allocate assets to AAA-rated bonds to protect against rising credit risk. He forecast China’s economic growth may decelerate to 7 percent next year, the slowest since 1990, from 7.5 percent in 2013. The government in March set a 7.5 percent target for this year.
There is a “de facto phenomenon of economic crisis,” Xia Bin, a former central bank adviser, wrote in a China Business News commentary on July 15. A crisis will mean bankruptcy for some companies and financial institutions, Xia said.
China’s credit-default swaps, contracts insuring the nation’s debt against default, jumped to a 17-month high of 147 basis points last month, before easing to 96.5 yesterday, according to CMA data. The yuan strengthened 0.03 percent to 6.1392 per dollar as of 12:04 p.m. in Shanghai, according to the China Foreign Exchange Trade System.
China’s economy is in urgent need of supportive fiscal and accommodative monetary policies, Hu Yifan, Hong Kong-based chief economist at Haitong International Securities Group Ltd. (665), wrote in a note yesterday. “With lackluster domestic and foreign demand, liquidity issues have arisen in SMEs amid the tightened credit policies of banks.”
She added that co-guarantee loans are common and have triggered chain reactions when one firm is at risk.
Chinese regulators reined in money supply in June in an effort to force investors to shift funds out of shadow banking, which allows lenders to bypass controls and capital requirements. It includes entrusted loans, trust lending, bills and underground lending.
“The government’s crackdown on shadow banking has left fewer financing channels available for lower-graded companies,” said Dong Hui, a bond analyst at China Securities Co. in Beijing. “Fewer ways to raise money they are in need of will increase those companies’ default risk.”
Total fundraising in the economy declined to 1.04 trillion yuan in June, from 1.19 trillion yuan in May and 1.78 trillion yuan a year earlier, central bank data showed on July 12. New loans accounted for 83 percent of aggregate financing last month, up from 52 percent in June last year.
“The downgrades show that the rating agencies have reached a consensus that the economy will be on a downward trend and companies’ financials will worsen,” said Cheng Qingsheng, a bond analyst at Evergrowing Bank Co. in Shanghai. “The first bond default is getting closer and closer.”