Market Commentary – A Black Swan in the Chinese Corporate Bond Market?

Recent bond defaults in China has aroused concerns of creditworthiness of the companies in the corporate bond market. Market jitters, coupled with already depressed yields, results in a temporary “spike” in bond yields and credit spread. What has happened and what is the real issue? Is there any likelihood of a black swan in the Chinese bond market? We believe that multiple bond defaults might actually be a good phenomenon in the long run, as their previous credit spreads are unjustified by their fundamentals. This is also a much-needed warning to all bond market participants, especially investors in the wealth management products that a “guaranteed” return is, in essence, not guaranteed. However, a black swan event is unlikely given a relatively benign monetary policy, as well as a favorable asset allocation bias towards bonds.

AA+ rated SOE suspended trading, causing jitters in the market

There have been several cases of bond defaults early in the year, but none of which equals the impact of the Chinese Railway Materials Company(CRMC)’s trading suspension. On April 21st, the company announced a sudden trading suspension of its 16.8 billion RMB worth of debt, of which a large portion is due on May and June. It is expected that a debt restructuring is definitely needed to avert a default, but the company has been in financial woes for long. Following the potential default of CRMC, 51 new issuance cases of corporate bonds have been cancelled, of which central and local SOEs account for 35% and 47% of the total amount respectively.

CRMC is the major trading company of domestic industrial commodities, such as iron ore and coal. But its major transportation vehicle is diesel rail carts, which has been substituted over the years by other electrified rail carts.  The company’s  receivables have long been rising since 2012 and there have been more asset writedowns than ever. The company resorted to issue super short-financing bonds with maturity less than 3 months, but was unable to save it from the brink of insolvency.

(CRMC has been debt-ridden for long, and its operating performance has been atrocious)

bond-1

Ironically, the company was AA+ rated by domestic rating agencies before the credit event. The main reason for that was the general perception that a state-owned enterprise with such a strategic importance is “too strategic to fail”. This credit event is a heads-up to both rating agencies and investors that creditworthiness doesn’t really have a shell to hide, even if it is for a strategically important state-owned enterprise. Meanwhile, default may not be a bad option for debt-ridden SOEs, as they clearly find default cost to be lower than it seems and they might find it preferable to default as soon as possible to get preferential treatment in restructuring initiatives.

A tough environment for corporate bonds in 2016 – a supply-side issue

Credit events signal interest payment failures, which in turn could lead to wider credit spreads and further financing difficulties for companies who have excessive liabilities and limited cashflows. The debt rollover is a strategy widely used in the past, but the tough economic environment in the industrial sectors have led to increasing likelihood of defaults. From a policy perspective, monetary policy has been benign since mid last year, in order to avert the vicious spiral of a debt-induced recession. But the yields have been compressed to an extreme – take a AA- rated one-year short-financing bond only has a yield of 4.75% in mid-March, much lower than the historical average of 6% and only has a mild credit spread of 2.57% at its lowest (over the treasury), much lower than historical average of 3%. Since CRMC’s credit event, the credit spread has been widened by 62 bps in 30 trading days. Credit spread widening has been prevalent across corporate bonds of different tenures.

(See the chart below for credit spread widening for short-term financing bonds since the lowest point this year in Mid-March)

bond-2

Credit spread widening is the cause rather than the reason behind the bond market jitters. Spike in supply have been a structural concern for a while- in our previous analysis of the NPC budget (https://cnspoon.com/2016/03/10/fiscal-stimulus-or-not/), we have already pointed out that at least 1.62 trillion RMB worth of additional central and local government bonds will be issued in 2016 as major source of funding for the fiscal budget, representing a 34% increase from last year. Local debt swap program’s volume is actually much larger than what the budget suggests and far more unpredictable. The debt issuance for government bonds has in fact been front-loaded. According to Chinabond.com, the overall bond depository volume – represented as the overall holding of bonds – have seen an increase of 26.2% YoY increase. Government bonds have seen a 54.4% increase on a YoY basis, with YTD government bond holding increasing by 869 billion RMB, with the pace likely accelerating in the 2nd quarter. Front loading of government bond issuance(holding) crowds out the room for corporate bond holding, a potential blow for struggling companies who are relying on debt rollover to refinance.

Why a temporary suffer could turn into a something good long-term

Despite general market jitters of credit risks, there is no sign that the bond market will face a general liquidity crisis like the money market liquidity crunch in June 2013, where yields and credit spreads shot up tremendously. The reason behind this is not only because of the general policy support by the government to increase bond financing as a means to diversify away from bank financing, but also a  general asset allocation move into more bonds. As of March, 2016, Funds’ overall bond holding has increased by 80% YoY, or 15% higher than 2015 year-end. General bond holding by funds has accounted for 38% of total bond holding, much higher than 23% of the holding same time last year. In June 2015, private equity funds are allowed to invest in interbank bond market, granting more channels for the general population to increase bond exposure. The compressed credit spreads since late 2015 was also the result of an asset allocation move, but the tightening gap may not be reflective of the fundamentals: out of the 961 enterprises that have disclosed annual audit report of 2015, 404 has shown a decline in revenue growth, 196 has negative operating cash flows, 102 has a EBIT/Interest ratio below 1. The case for a further bond market boom looks stretched in this case.

Increasing bond allocation has also been partially supported by expanding leverage by means of interbank bond repo , which amounts to 3.3 trillion RMB, but the increase in leverage is not explosive (10% YoY), and the number has actually gone down from year-end 2015. Meanwhile, the nature of such repo is different from margin loans in the stock market, as institutional investor used repo as a means to exploit arbitrage between coupon rate and the repo rate, which has far less risk than naked margins in the stock market.

With a lenient funding environment, allowing unsound enterprises to default is not a bad move, as the overall economic objective in 2016 was to reduce the cases of zombie firms and bad loans. Furthermore, it is necessary for credit spreads to mean-reverse to its norms, so as to reflect the actual fundamentals in the economy.  However, the real challenge here is to avoid moral hazard, as firms might find default to be less costly than timely interest payments and deliberately opt for defaults. Thus, disciplining the market is a delicate balancing act, as defaults might be a preferred choice for certain enterprises, and this is where the government should use legal and policy tools to ensure bondholders’ interests are well protected. While more default cases might be the norm for Chinese bond in the coming years, a black swan event is unlikely to occur, albeit the fact that monetary policy is unlikely to loosen further going forward.

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