Bond investors in China starting to insist that price reflect credit risk
Default of a credit product and worries over the proliferation of shadow banking system see mainland players questioning old assumptions
Having traded for years almost oblivious to the notion of risk, China's bond market - Asia's biggest outside Japan - has begun exhibiting characteristics of a genuine credit culture, with onshore investors demanding higher premiums for weak borrowers.
In the past, investors had operated under the belief that the state would always step in to prevent a default.
But a recent default of a credit product and growing worries over the proliferation of a shadow banking system extending off-balance-sheet loans have made them question old assumptions.
Hence, lenders have begun differentiating on the basis of industry fundamentals, the degree of state support and balance sheet size, making the credit curves steeper as the gap between the strong and weak names widens.
"There is no dearth of potential defaulters. But, when there is confidence of a bailout, there is no fire sale even in the stressed names, because of confidence that principal will be repaid despite missed coupons," said Becky Liu, a Standard Chartered strategist.
"The situation is starting to change."
Last month, AAA-rated Beijing State-Owned Assets Management sold bonds carrying a coupon of 6.48 per cent, 242 basis points less than a coupon paid by AA-rated Ningxia Baota Petrochemical.
Similar bonds sold in December had showed a narrower gap between top-tier and second-tier issuers.
Shaanxi Coal, rated AAA, sold 2018 bonds at a coupon of 6.48 per cent, but AA-rated Anhui Foreign Economic Construction had to pay just an extra 132 basis points for its five-year bonds.
But while the trends are positive, the situation is only starting to change, as analysts say most investors still nurture a belief that Beijing will step in rather than allow a default that could drain confidence from the market.
Unlike in mature markets, where an AA rating is considered strong, investors deem anything below AAA in China to be weak.
The spread between high and low-risk borrowers, according to Thomson Reuters benchmark curves, has widened to a 21-month high of 105 basis points from about 70 basis points in mid-2013, when China's money markets suffered a short-lived liquidity squeeze that sent tremors well beyond its borders.
Yet, China's AA-rated bonds now yield only 10 to 15 per cent more than those issued by the top-rated borrowers, which is still less than half the spread between top-tier and speculative-grade bonds in Western countries.
Since mid-January, the gap has widened by 20 basis points, after Industrial and Commercial Bank of China, the world's largest bank by assets, said it would not finance a repayment to investors in a troubled off-balance-sheet investment product that it helped to market.
In the end, an unnamed investor stepped in with a bailout, although the media had previously reported that the local government, ICBC and the trust firm would share the costs of a bailout.
Worries intensified as the issuer of a 3 billion yuan (HK$3.8 billion) high-yield investment product, backed by a loan to a debt-ridden coal company, failed to repay investors when it matured on January 31.
This month, the issuer of a high-yielding investment product sold through China Construction Bank, the country's second-biggest lender, failed to repay investors when it matured on February 7.
Negotiations are continuing over the return of funds to investors in the product, created by Jilin Province Trust and backed by a loan to a coal company, Shanxi Liansheng Energy.
These upsets come on the heels of a report by the state auditor that showed an alarming build-up in local government debt and have kept investors on the edge about debt servicing in the world's second-largest economy, as it grapples with excess capacity in certain sectors.
There are now fears that some debt obligations may not be met, since the money was used for building non-lucrative infrastructure.
The authorities have tried to calm these anxieties with assurances the National Development and Reform Commission will pay close attention to local government debt issuers, providing them with investment guidance.
Bond investors are also playing their part.
"Local investors are doing more due diligence and analysing the degree of state support, as well as other credit-specific factors in their analysis of credits," said Desmond Fu, a rates strategist with Western Asset Management.
Still, there is unfinished business, as the premiums demanded by onshore investors lag those that exist in offshore markets.
The discrepancy is because of the difference in access to bank finance and could diminish as the People's Bank of China tries to rein in the shadow banking sector, potentially choking off small builders from funding.
"The PBOC is watching bank lending carefully, and that's the environment where the credit spreads should widen, as the market tries to figure out who has back-up credit if they need it," said Cliff Tan, the East Asia head of global markets research at Bank of Tokyo-Mitsubishi UFJ.
Tan said this credit differentiation between competitors on the basis of size was evident in many sectors.
"It is starting to behave like a credit market," he said. "The degree to which credit risk is priced in China waxes and wanes over time - we hope for China's sake the trend is increasing."