Shanghai Chaori Solar Energy Science and Technology has announced it could pay only four million yuan (HK$5 million) of an 89.8 million yuan interest payment to bondholders falling due tomorrow.
Barring last-minute intervention by the authorities or a friendly state bank, this will be China's first default on a domestic bond.
The event marks a new era in the debt market where investors can no longer assume all debt is risk-free.
"The Chinese government is breaking its implicit guarantee on all domestic bonds," said Lu Ting, a China economist at Bank of America Merrill Lynch.
Analysts and investors have been widely expecting to see defaults this year after the country's leaders talked during a party plenum in November last year about the need for the market to play a "decisive role", which many interpreted as letting investors take losses on bad investments.
The big question is whether the market will take the first default in its stride or whether it would trigger more defaults from issuers seeking to refinance debt.
More than 10 trillion yuan in bonds and trust instruments were maturing in the domestic market this year, HSBC said.
The year will see a tripling from last year in the volume of bonds coming due to US$173 billion, said Thomson Reuters.
Lu sees a default as positive, imposing discipline and real pricing for credit risk on the mainland debt market, the world's second-largest.
"This is the essential stuff of a financial market. If the market cannot price risk very well, then those [issuers] with low risk will have to pay a higher rate. Those with higher risk would pay a lower rate … this is no good," he said.
Moody's analyst Ivan Chung struck a more cautious tone, adding there was no system on the mainland for investors to press claims against a firm in the case of a default.
Chung said investors did not know how to proceed with a restructuring or a recovery of assets. "I don't see any panic withdrawal from the market, but it's inevitable there will be volatility in trading," he said.
Since the plenum, the spread over treasuries for AA-minus rated corporate bonds has been widening relative to AAA-plus issues, reflecting greater differentiation between bonds still deemed risk-free and those with potential for default.
"We do expect onshore default, and we think it's a good thing, and is typical during reforms. The market will increasingly differentiate the good and bad, and price them accordingly," said Gordon Ip, a fund manager at Value Partners.
Chaori, which makes solar cells, issued in 2012 a one billion yuan, five-year bond with a coupon of 8.98 per cent. Questions about repayment emerged after the company's shares were suspended from trading on the Shenzhen exchange in December 2012 on speculation its chairman had stolen company funds, said a report from Bank of America Merrill Lynch.
Chung said the authorities might have singled out the firm as a test case for the nation's first default, saying "it's isolated with no systemic risk to the bond market".
China's solar cell sector is struggling with overcapacity. Another firm, LDK Solar, is negotiating a debt-for-equity deal with foreign investors on a US$280 million bond for which interest has been due since August last year. The firm also has 500 million yuan in domestic notes due in December.
Wealth management instruments issued by the mainland trust sector are brushing against default. A 289 million yuan wealth management product linked to Shanxi Liansheng Energy passed its February 7 maturity date without paying investors, technically a default. A three billion yuan wealth management product linked to bankrupt coal miner Zhenfu Energy came close to default when it matured in January. China Credit Trust, which issued the instrument, repaid investors using its own funds.
A Moody's report said mainland property firms were exposed to refinancing risk should investors withdraw from the wealth management market.
It said 61 per cent of rated developers had trust loans outstanding, with Hopson Development, Coastal Greenland and Glorious Property having material exposure to trust loans and would face refinancing difficulties if capital dried up.
"Many people think there will be a massive run on the bond and trust market," Lu said. "But they underestimate the resilience of Chinese investors."