Risks rising in China high-yield bonds, default could spark contagion
The trickle of Chinese bond defaults in recent weeks has been a reminder that China’s economic slowdown is inflicting real distress, despite its soaring stock markets. Although high-yield bonds have also rallied, they cannot stray too far from economic reality, as ultimately coupons must be paid.
For now the Chinese high-yield bond market appears to be the latest high beta "risk on, risk off" trade. Bonds are benefiting from a bullish stock market and monetary easing of the Chinese government, even as economic indicators deteriorate.
The "risk on" trade assumes that Beijing can successfully steer a course to its "new normal" era of slower growth and avoid a property market collapse or debt crisis. Yet this conviction is primarily based on fear: the social, economic and political repercussions of failure are so unpalatable that policymakers will not allow a "hard landing."
The result is a market displaying irrational exuberance on the upside, as well as exaggerated price swings on every piece of bad news due to the absence of visibility that the "risk off" scenario can be avoided.
The recent strong performance, however, should not mislead high-yield bond investors from the fact that risks are rising as China’s economy confronts the twin problems of excessive debt and a deflating property bubble.
While the leadership’s "new normal" slogan explicitly recognizes that growth will be decisively slower going forward, there has been less commentary on the financial implications. China must now grow without a blank check: one way or another the pace of credit growth is going to have to slow and the implicit guarantee on state owned enterprise (SOE) debt removed or loosened.
The most pressing problem for Beijing right now is how it deals with local government debt, which has risen to 16 trillion yuan (US$2.6 trillion) according to Chinese media reports, a 47 per cent increase from June 2013.
Any default risks considerable contagion because provincial governments rely not only on income tax for revenues but on selling land and engage in multiple commercial activities through local government financing vehicles. The financial fallout could deal a considerable blow not just to local economies and property markets but also the banking sector given the pervasive role real estate serves as collateral.
Hence, the belief that Beijing is willing and ready to intervene. Yet the fact that policymakers recognise the problem does not in itself remove risks. The recent backtracking on a local government debt swap deal and speculation that the People’s Bank of China will directly intervene to buy bonds, suggests efforts to clean up debt could be protracted. Most likely we will see a pragmatic "muddling through" approach rather than a "do what it takes" style unlimited bond buying.
Bond investors are left in a difficult position that they must somehow assess potential default risks that are inextricably linked with politics.
The recent anti-corruption crackdown mandated by Beijing has led to various arrests of government officials, some with close ties to major corporates. This clearly highlights the need for greater scrutiny of major shareholders.
This means not just understanding ownership but also where and how wealth was acquired. While it is difficult to second-guess China’s anti-corruption campaign, investors need to be following the trend in corruption cases as it moves from industry to geography. For example, recent reports suggest a quarter of Chinese SOE executives investigated for corruption worked in the energy sector.
Investors also need to pay particular attention to under stress industry sectors and those deemed no longer strategic where an implicit state guarantee may be removed. In times of economic stress it is also important to be vigilant for accounting fraud as firms attempt to make their numbers look better.
For now the liquidity ride may be exhilarating, yet conditions could quickly change. Investors in offshore high-yield Chinese bonds need to remember they are highly exposed if China’s leaders find they ultimately cannot restore growth.
If push comes to shove, expect Beijing to always put employees, domestic banks, the taxman and local bondholders first.
Michel Lowy is co-founder and chief executive of SC Lowy