Why China’s bond defaults could ultimately boost investor confidence
Despite heightened levels of distress in China’s US$15trn credit space1 , investors stand to potentially benefit from a new path for the onshore and offshore markets as they more efficiently price credit risk.
At first glance, several high-profile bond defaults in late 2020 are a justified cause for concern. This trend might well continue this year, too. If so, it has the potential to create tension with the country’s post-COVID-19 economic rebound – but the short-term impact might well provide potentially longer lasting benefits.
Given that the affected names are state-linked companies with relatively weak fundamentals, increasing differentiation is emerging in this cluster of issuers. In turn, this reflects the broader strategic vision of the government to enhance the overall quality of the fixed income landscape.
This doesn’t downplay the situation. The default by chipmaker Tsinghua Unigroup, for instance, on $450m of debt, also triggered cross-defaults on another $2bn – equivalent to almost two-thirds of total defaulted debt in China’s offshore bond market in 2019.2 Other state-owned enterprises (SOEs) to default included mining firm Yongcheng Coal and Electricity Holding Group and Huachen Automotive Group Holdings.
While the trio of defaults theoretically raises systemic risk, in practice we think this does not pose an ultimate risk to the onshore financial system.
Before this flurry, corporate defaults had been edging higher for around six years. This has been in line with a growing acceptance of market mechanisms due to Chinese government regulators’ preference for deleveraging and generally reforming funding practices.
The government would potentially rather see deleveraging through voluntary restructuring where losses can be absorbed in an orderly manner broadly across the market.
Notably for investors, a positive implication of the defaults will likely be a more efficient debt market as well as more disciplined and effective investment on the part of issuers. In short, the knock-on effect might improve the accuracy of pricing risk and enhance transparency. This aligns with efforts by the People’s Bank of China (PBoC), the country’s central bank, to strengthen its oversight of the ratings industry.
LGFVs in China: Rising leverage, rising issuance and the need for investor discretion
The defaults and subsequent depressed investor sentiment in the short term have also shone a spotlight on bonds issued by local government financing vehicles (LGFVs).
These are an important and growing segment of the both the offshore and onshore Chinese corporate bond markets – and one which cannot be ignored, by investors or government regulators, as a result of high debt levels and relatively low operational transparency.
While no LGFV borrower has yet defaulted on a bond, they are not a safe haven. And in keeping with the hunt for quality amid growing investor risk aversion, new issuance is likely to come from LGFVs in more developed regions such as Zhejiang and Jiangsu provinces.
With this in mind, it’s widely expected that the impact of recent defaults on investor appetite for many otherwise high quality, higher visibility LGFVs will only be short-lived given their important public policy roles. In addition, these vehicles benefit from ample liquidity onshore and usually have diverse credit profiles.
In fact, Moody’s predicts LGFV bond issuance in both the onshore and offshore markets will increase in 2021 from last year’s levels. In particular, increasingly attractive international funding costs have the potential to boost offshore issuance this year from a low base in 2020.5
Recent data from Moody’s
|Debt outstanding as of Sept 20, 2020||Onshore (in RMB trillion)||% of total||Offshore (in USD billion)||% of total|
|Sourced & LGFV defined by Wind||Sourced from Bloomberg & Dealogic; LGFV defined by Bloomberg|
This is partly due to how post-pandemic themes will likely support LGFVs. A certain bullishness among onshore investors is based on their perception of government efforts during the pandemic, including investing in infrastructure to ensure social and financial stability. Fitch Ratings, for instance, has cited the potential for LGFVs to leverage their experience to help spearhead such an initiative.6
For offshore investors, meanwhile, the refinancing of US dollar-denominated bonds by repeat issuers such as Yiwu State-Owned Capital Operations, have been well received, evidenced by large investor over-subscriptions and narrowing spreads7 . In 2021, roughly $25bn of bonds are due for repayment or refinancing8 . Plus, the need to diversify funding channels might drive more debut LGFV issuers to the offshore market.
More prominent in portfolios
Scepticism among some investors about LGFVs can be tempered by the fact they are state-owned. Further, being controlled by a local or regional government is not necessarily inferior to central government ownership.
As a subset of SOEs, therefore, LGFVs can be evaluated in a similar way in terms of clarity of purpose and strategic importance when determining how much credit enhancement state ownership contributes.
According to S&P Global Ratings, ongoing SOE reform is feeding through to LGFVs. The rating agency believes that over the long term, off-budget risks will be better controlled as LGFV borrowers become more disciplined – for example, improving debt coverage by growing their own revenues.9
China’s Financial Stability and Development Committee has lent weight to this view. In late November 2020, in a meeting to regulate bond market development and maintain stability, the outcome was a stance of zero tolerance towards illegal activities, including fraudulent issuance, fraudulent disclosures, malicious asset transfer and fund embezzlement.10
At the same time, more defaults are inevitable and – in our view, from a big picture perspective – necessary to improve market efficiency. Our previous research, for example, highlighted that single-B issuers globally default at an average annual rate of close to 3%, and 20% cumulatively over a five-year period11 . The cost of funding innovation in an economy will be some level of credit defaults.
The key to ensuring that defaults don’t lead to widespread disruption is transparency around these risks and efficiency in terms of pricing and placement of credit risk. By many indications, China is working towards these goals for the benefit of increasing investor confidence over the long term.
All companies mentioned are for illustrative purposes only and should not be considered as advice or a recommendation for an investment strategy.
- Source: AXA IM, based on data from 1990-2016H1 Moody’s