Business & Money | Tuesday 9 August, 2016 7:21 am |

Alex Yao, Fixed Income Research Analyst, Union Bancaire Privée (UBP)

The rise in recent negative headlines on China has sparked investor concerns and may have a broader impact on Asian credits.

China’s debt market is facing increasing downside risks in the near future. A series of events starting from the soft macro data to negative credit ratings to increased corporate defaults have dampened investor confidence in the world’s second largest economy.

Soft macro data a market reality   

The market has acknowledged China’s slowing growth.

China’s year-on-year GDP growth shrunk from over 12% in 2010 to a little under 7% at the end of 2015, inching closer to the country’s minimum 6.5% annual growth target.

However, there are concerns whether China can sustain its 6.5% growth target to 2020 as reduced productivity, slowing investment-led demand and higher debt levels are already taking root in the market.

System debt levels are also a cause for concern. The current total debt (corporate, household, government and bank debt) to gross domestic product (GDP) ratio of 246% is relatively high against the backdrop of declining productivity levels.

Since 2010, purchasing managers’ indices (PMIs) have shown slower services growth and manufacturing contraction in seven out of every 10 months. Declining industrial profits will only add further pressure on corporate loans provisioning.

 

 

Rating agencies are concerned too

China’s declining growth has led credit rating agencies, Moody’s and S&P, to change the country’s AA-, Aa3 sovereign rating outlook to Negative from Stable in March 2016, respectively.

These new ratings reflect reduced fiscal strength and foreign reserves due to capital outflows, as well as uncertainty over the Chinese government’s ability to introduce reforms and address the economic imbalance.

There is also a large risk with the government’s sizeable contingency liabilities in case things go wrong. These liabilities may materialise on the government’s balance sheet due to high debt levels across the economy and stressed-out SOEs. Debt issuers that have a degree of government support will be exposed to potentially weaker support in the near future.

As a result, Moody’s has revised the outlook of 39 government-related issuers to negative while S&P has revised the outlook of 20 SOEs.

Increased default in steel, cement and coal

Since the first bond default by Shanghai Chaori Energy in March 2014, at least 25 corporate bond default cases have been reported in China to date.  More than half of the defaults were from sectors with over-capacity such as steel, cement, and coal. Issuers from these sectors also made up 54% of the issuance amount of bond defaults.

Although there has been an increase rate in bond defaults (15 cases year-to-April  compared to 10 in 2014) the total defaulted principal amount is currently at a manageable RMB23bn or 0.14% of the total corporate bond balance.

This defaulted principal amount is notably lower than that of trusts (0.6%) and bank loans (3.64% accumulated bank non-performing loans rate). The lack of cross default clauses on local bonds have also partly contributed to the low delinquency.

However, the type of issuers in the default list is a cause for concern.  More SOEs – including central and local SOEs – are in the default list. Baoding Tianwei, an electric transformer manufacture, became the first SOE to default on a domestic bond last April. Sichuan Coal Industry Group, became the latest state owned company to miss interest and principal payment on its onshore bond issue.

Investors can no longer expect China’s state-backed companies to have ironclad support from the government. The proposed debt-restructuring of SOE China Railway Materials Company Ltd (unrated) also signals the Chinese government’s reduced support for SOEs in sectors that are declining or of low strategic importance.

This raises the million-dollar question – which sectors are deemed strategic enough and which will not receive support in case of default.

 

 

Steeper credit curve as market discount support

Recent moves in China’s credit spread seem to indicate that the market has shifted its focus from assuming overall implicit support to differentiating between issuers.

Funding costs has gone up – China AAA-rated onshore credit spread increased by around 35 basis points since the start of the year.

Bond yields of issuers in over-capacity sectors also widened out further compared to the general market. Yields in April this year rose at its fastest pace in more than a year.

Onshore bond issuance declines amid market concerns

Chinese corporates have significant refinancing needs as a record RMB3.87trn worth of local bonds are due to mature this year, with the next bond maturity peaking in August when about RMB80BN is due, and the biggest bond payments are concentrated in the most cash-strapped industries.

Dampened investor confidence and higher funding costs have led to increase cancellations of bond issuance in recent weeks.

According to international news agency Bloomberg, at least 103 bond issuances or RMB117bn worth of bonds planned were cancelled in April. This has resulted in a relatively smaller amount of bond issuance in April of RMB300bn against RMB1.2trn in March. Net corporate refinancing in May plunged to a record low of minus RMB39.7bn as maturing debt exceeded new issuance.

China issuers go offshore for refinancing

Earlier in the second half of 2015, Chinese corporates aggressively tapped the domestic bond market for cheaper financing and used the proceeds to call or redeem the more expensive offshore bonds.

However, Chinese issuers, especially the lower-rated ones, have started to return to the offshore RMB bond market this year as funding costs rise – despite tightened controls on cross border outflows and rising strain on the banking system.

For example, Fantasia (rated B, B3) became the first Chinese corporate to issue offshore through a RMB600m offering of senior notes, due in 2019.

Despite the demand-supply imbalance the coupon was priced towards the higher end at 9.5%, suggesting higher investor premium.

Expect more high-profile default events

We expect corporate fundamentals to weaken amid slowing economic growth and increased headline corporate credit events onshore, including the weaker SOEs.

Under the Chinese fiscal law, there are limitations for Chinese regional and local governments to provide direct financial support for their SOEs. Funds to support SOEs must be budgeted and approved by the local Congress that usually meets once a year.

 

As a result, regional and local governments are helping trouble SOEs to negotiate with banks to roll over debt and provide additional funding or use other SOEs to conduct a bailout.

However, there is reduced appetite for credit bailouts as bank management teams are becoming more vocal in reducing funding to over-capacity sectors. There is also varying economic and fiscal capability among the local and regional governments to support troubled SOEs. Although they may still enjoy support from the central government, this may not necessarily translate into timely downstream support for the SOE.

Weak investment outlook for Asia bond market

We are underweight high-yield property as rising bond yields will translate into higher funding costs for these highly leveraged corporates with significant refinancing needs.

We also feel that the Asia bond market will see weaker technical support as supply picks up when Chinese corporates look to satisfy their higher refinancing needs with offshore funding. As it is, valuations already look rich for Asia credit compared to global markets.