China’s First Bond Default Suggests a Reform Attempt

After Cloud Live default, is Beijing changing its bailout policy?
April 13, 2015 Updated: December 10, 2015

Last week, Cloud Live Technology Group Co. became the first Chinese company to fail to repay its onshore bonds.

The lack of support from the Chinese Communist Party is surprising. In the past, authorities would typically step in to provide last-minute funding or debt restructuring to avoid a default.

But no one has stepped in for Cloud Live, which could signal a change in official policy to reform the Chinese bond market, in an effort to deleverage corporations and rein in excessive risk-taking by investors.

If true, more onshore defaults should follow, which would increase yields significantly in the Asian junk bond market.

Cloud Live said it only raised 161.4 million yuan ($26 million), or 240.6 million yuan short of the amount needed to repay debt totaling more than 400 million yuan, according to a regulatory filing in Shenzhen, where the company’s stock is listed. The payment was due on April 7.

Chinese authorities have been reluctant to let companies default.

The company, which was predominantly a restaurant business, went into cloud computing late last year. The bonds were originally issued in 2012 with a 6.78 percent coupon. Yields on the bonds jumped to over 20 percent in early April as the company’s financial position worsened. (A bond’s price and yield move inversely.)

Corporate Bailouts

Market watchers have long expected defaults in China’s junk bonds, which sit squarely in the junkiest corner of the junk bond market (also known as high-yield bonds). Over the last several years, middle-market Chinese companies and investment firms issued bonds on top of bonds, selling them to mostly retail investors hungry for higher returns.

But contrary to letting market forces play out, Chinese authorities have been reluctant to let companies default.

Take Shanghai Chaori Solar Energy Science & Technology Co. for example.

In March 2014, the maker of solar equipment defaulted on its interest payments and was in bankruptcy. But seven months later, the company unveiled a complex corporate restructuring plan to repay the debt. Jiangsu Golden Concord and eight other investors together injected 1.46 billion yuan of capital for a controlling equity stake. The restructuring forced most bondholders to take up to an 80 percent haircut.

Great Wall Asset Management, one of four “bad banks” set up by Chinese finance officials to purchase toxic assets from China’s “Big Four” state-owned lenders, issued a separate 880 million yuan guarantee to fully repay Chaori’s exchange-traded notes.

The guarantee was telling. For one, it placed the interests of small investors who owned subordinate exchange-traded notes ahead of institutional investors who held more senior bonds. It was also unclear what financial windfall, if any, Great Wall received in return for its guarantee.

The logic behind this is to avoid social instability by not letting investors incur losses. Excessive bond defaults could spark protests and social unrest, threatening the power of the ruling Party.

Unlike in the West, where investor psyche has been honed over the generations to expect losses, Chinese retail investors are still learning about investing. In China, households are traditionally taught to sock away money, and value retention is considered to be paramount to gains.

The Shanghai Stock Exchange has only operated for 23 years (almost entirely in a bull market), so most small-time investors haven’t lived through too many downturns. Because of expectations the Party has created about its outsize role in the economy and society, Chinese people have been trained to associate their wealth, fortune (and misfortune) with the Party’s policies. If the current period of investment gains suddenly comes to an end, the public will look to the regime for blame.

“The way the government dealt with Chaori’s default suggests that it is afraid of potential protests by retail investors,” Yang Delong, a fund manager at China Southern Fund Co., told the Wall Street Journal at the time.

Shift in Policy?

But that paradigm might be changing. Cloud Live isn’t the first Chinese firm to default, but it may just be the first to not receive a bailout. China’s official news agency Xinhua called Cloud Live’s default “precedent-setting.”

At the 2014 National People’s Congress (NPC), Premier Li Keqiang said corporate defaults would be unavoidable. In fact, Chaori and another company last year were the first two onshore bond defaults in history. While bondholders were eventually paid in both cases, the events were the start of a slow shift in official thinking on bond defaults.

Since last year, China’s economic growth prospects have become more precarious. The debt-laden manufacturing and technology sectors are especially at risk. At this year’s NPC, Li’s carefully worded statements said that China will tolerate individual cases of financial risk.

Cloud Live recorded a net loss of 60 million yuan in Q1, and had losses in excess of 500 million yuan in both 2013 and 2014. According to the South China Morning Post, former Cloud Live Chairman Meng Kai was under investigation since last December for certain securities regulation violations. He subsequently resigned from the company’s board.

While Cloud Live is a relatively small company, the decision to let it default is historic. As Chinese regulators are likely to allow further bloodletting, investors will need to begin performing more due diligence before investing in onshore corporate debt.

Junk Bond Market Reaction

Broadly speaking, Asia’s junk bond market is in the midst of a rally. As of last Friday, the benchmark high-yield J.P. Morgan Asia Credit Index rose 1.2 percent from the beginning of the month, after rising almost 3 percent over the last two months.

Chinese market reaction to Cloud Live’s default has been muted. Last Wednesday, Cloud Live’s Shenzhen-listed stock jumped almost 10 percent, signaling that some investors were betting that a bailout would eventually come.

But fundamentally, China’s high-yield market remains dicey. A selloff in January was triggered by Shenzhen-based real estate developer Kaisa Group Holdings Ltd.’s failure to pay interest on offshore bonds. That event jolted the market and virtually halted new issuances.

Many Chinese firms are already grappling with high debt levels amid slowing economic growth. Throw in Beijing’s new willingness to allow more corporate defaults, and the Chinese junk bond market just became too risky to stomach.