More Pain Ahead for Chinese Bond Market

November 29, 2020 Updated: November 30, 2020

News Analysis

This isn’t as much hyperbole as it sounds: the main reason investors bought bonds issued by Chinese state-backed companies is an implicit guarantee from default by the local or provincial government.

That belief has been shattered by a recent spate of defaults by major Chinese state-owned companies.

Yongcheng Coal and Electricity Holding Group, a state-owned coal company, defaulted on a $152m bond in November. At the time of the default, Yongcheng was a AAA-rated company by Chinese domestic credit rating agencies. This became, pun unintended, the proverbial canary in the coal mine. 

Shortly thereafter, Tsinghua Unigroup, a state-backed technology company affiliated with Tsinghua University in Beijing, also defaulted on its debt. 

Yongcheng and Tsinghua’s defaults are seismic. Both are major state-backed companies. 

An analysis by Yicai, a Shanghai-based business media, found that a total of 149 bonds issued by 58 Chinese companies defaulted during the first ten months of 2020. The principal value of the defaults totaled 81.7 billion yuan ($11.6 billion).

More than half, or 49 billion yuan, were bonds from six companies within the coal industry. The real estate sector also saw significant defaults, with four developers failing to repay their bonds. 

The recent string of defaults has rattled issuers, with several companies pulling their planned bond issuances in recent weeks.

Policy Pivot

In a departure from the previous decade, there appears to be a policy shift in how Beijing treats financial risks going forward. The People’s Bank of China Governor Yi Gang penned a series of editorials beginning on Nov. 17, addressing the financial structure and policy risks facing China going forward.

Yi’s commentary is surprisingly frank. He points out that China’s financial leverage has increased over the ten years ending in 2018, both in terms of bank loans to GDP and debt-to-equity ratios at companies.

The central bank governor also pointed out that certain “risk-bearing” investments don’t actually bear risks due to the existence of implicit guarantees. With regards to this, Yi only mentions the so-called “wealth-management products” peddled by insurance companies and trusts, but the parallels to China’s bond market are difficult to ignore.

He also blamed some of the risks to “non-bank” entities engaging in banking activities, perhaps alluding to the recent high profile legislation over the online lending industry which scuttled Ant Group’s IPO last month. Banks, on the other hand, are more closely regulated and monitored by the government.

‘Zero Tolerance’

In addition, Beijing has suggested that certain improprieties may have occurred with some bond issuers. 

Vice-premier Liu He, one of China’s top economic authorities, warned borrowers in November that the Chinese Communist Party (CCP) has “zero tolerance” for financial misconduct. Liu said companies engaging in misleading representations or making attempts to evade repaying debts would be punished.

This is the first time that regulators have brought up financial duplicity as a major risk for bondholders broadly, but recent events have backed up those assertions.

A Singapore-based creditor of Brilliance Auto Group Holdings Co., filed arbitration to freeze its assets in November just as its parent company—Liaoning Province state-owned company Huachen Group—entered bankruptcy restructuring, claiming that the parent company was attempting to withhold assets from creditors after a bond default in October. Brilliance is the parent company of BMW AG’s China joint venture.

Yongcheng, the coal company backed by Henan Province, also faces asset-stripping allegations from creditors. 

Some investors alleged that Yongcheng transferred shares of Zhongyuan Bank Co. Ltd. it had owned to other Henan state-owned companies prior to defaulting on its debt, shielding the assets from being claimed by creditors in a restructuring proceeding, according to a report by Caixin Magazine.

Higher borrowing costs are already manifesting themselves. The average interest rate for primary bond issuances for Chinese state-owned enterprises is 5.7 percent since October, according to a Financial Times report. The 5.7 percent figure is around 1 percent higher than what new bonds paid during the first three quarters of the year.

While that may not sound like much, a 1 percent expansion in bond spreads is massive in such a short period of time. Investors are quickly repricing Chinese bonds, and more pain could come.