Growing pains for the Chinese corporate debt market

Defaults in a fast-growing market

China’s onshore corporate bond market has experienced rapid growth over the last decade. It now represents roughly a quarter of China’s overall onshore bond market, which has expanded 5x over the last decade to its current size of c. RMB111tn (US$16.3tn) in principal outstanding. However, a number of recent corporate bond defaults by state-owned enterprises (SOEs) has shaken investor confidence, refocusing attention on this market¹.

In November, Yongcheng Coal & Electricity, a key subsidiary of Henan Energy and Chemical Industry Group (HECIG) defaulted on its outstanding onshore bond obligations, triggering cross defaults on all of its debt. HECIG is a State Owned Enterprise, that in turn belongs to the State Owned Assets Supervision and Administration Commission (SASAC) of Henan Province.  HECIG is the largest entity in Henan province by revenue and a member of the Fortune Global 500 list of top companies by revenue, while Yongcheng is a leading coal producer in the region. Yongcheng missed a relatively modest coupon and principal payment of c. RMB1bn, despite having issued a RMB1bn note just 20 days before and receiving a RMB15bn equity injection from its ultimate parent at the same time. The default took many observers by surprise and followed other high profile SOE defaults, such as chipmaker Tsinghua Unigroup and Brilliance Auto Group, which also failed to meet repayment obligations.

The People’s Bank of China injected liquidity to provide support

These recent defaults unnerved some local institutional investors into redeeming holdings in funds with onshore corporate credit exposure. A broader sell off occurred and some funds suffered outsized losses as a result. At least three domestic bond funds failed to launch in November, while a few others became unavailable for new subscriptions from retail investors as regulators reassessed them as unsuitable. With overall liquidity conditions tightening and bank negotiable certificates of deposits (NCD) yields rising to stabilise onshore bond sentiment, the People’s Bank of China (PBOC) surprised markets on 30 November by injecting RMB200bn (US$30.4bn) of liquidity, despite having maintained a fairly hawkish monetary stance in recent months.

Figure 1 – Chinese SOE defaults; highly visible, but not many of them

Issuers’ total notional amount of onshore bonds outstanding at the time of default, as a percentage of total corporate bonds outstanding at the start of the year (%).

Source: Wind, company announcements, Goldman Sachs Global Investment Research.

Note: Defaults from privately placed corporate bonds issued before 2015 are excluded, as they relate to small sized unlisted companies with limited information disclosure.

The level of Chinese SOE defaults seen this year (<1% of overall SOE debt outstanding) is low relative to global credit markets, and comparable to the proportion experienced in the country over recent years, as shown in Figure 1. These cases, while highly visible given the profile of the defaulting entities, do not represent a spike in SOE defaults in our view, but represent company specific liquidity issues linked to the effects of COVID-19 earlier in the year. The defaults have clearly shaken investor confidence, especially since these companies were all carrying the highest possible onshore credit rating (AAA) and many onshore institutional investors (with dedicated credit analysts) were caught by surprise. Doubts regarding the reliability of onshore credit ratings remain well-founded. More broadly, it has left investors asking whether something more systemic is at play and whether this will lead to wider issues in 2021.

A deleveraging cycle underway, temporarily interrupted by COVID

We view the latest series of bond defaults as part of the normal development of the onshore Chinese corporate credit market. All healthy credit markets must have defaults at some point in the cycle – it is a painful but necessary mechanism for the efficient functioning of the market, as shown in Figure 2. For some years now, Chinese regulators have been very conscious of the high degree of leverage in the corporate sector; the result has been an onshore deleveraging cycle that was temporarily interrupted by COVID. Now the pandemic is more under control domestically, Chinese regulators are prioritising a return to sustainable growth, while being alert to systemic risks.

Figure 2 – New onshore bond defaults had eased pre-COVID

China onshore bond defaults since 2014.

Source: Wind, Bloomberg, company announcements, Goldman Sachs Global Investment Research.

Please note that these charts have been redrawn by Ninety One.

This renewed focus has given rise to several new policies (including the Three Red Lines, designed to curb excesses, specifically in the property sector), which have led to a de-facto tightening of financial conditions throughout the market and isolated cases of distress as the Chinese economy recovers from the pandemic. Typically this has focussed on companies already facing cash flow difficulties. Some investors may choose to overlook these issues by taking comfort in the strength of these entities’ implicit ties to government or to stronger parents or siblings – however this is an approach that can be fraught with risks as the recent defaults have shown. In our view, there is no substitute to detailed fundamental credit analysis when investing – merely having an onshore presence and broadly investing in state-linked names may have worked in the past during more benign conditions, but a greater depth of market experience and analysis is likely to become required as credit conditions are tightened.

We continue to view Chinese fixed income as offering value for discerning investors prepared to do rigorous analysis. In a market still in its early stages of development, while onshore and offshore credit rating agency views are useful and relevant, we believe they are no substitute for a strong investor focus on bottom-up credit fundamentals. The recent defaults and subsequent dislocation in the markets are opportunities to invest in good companies at attractive valuations, in our view. While painful, we regard these recent defaults as signs of a maturing market and demonstrate the greater market discipline underway as China’s economy recovers. At Ninety One we remain committed to the onshore and offshore Chinese fixed income markets and focussed on aiming to deliver quality returns for our investors.

¹ The Ninety One All China Bond strategy and the EM corporate debt strategies do not have exposure to the defaulting entities.