Fall in emerging market junk bonds and domestic defaults spur China to action
Nicholas Spiro says the severe decline in emerging markets’ high-yield bonds so far in 2018 has two real, if seemingly contrary, benefits: it has given investors a more accurate assessment of these bonds’ real value, and it has prompted China’s government to enact stimulus measures – meaning Asian junk bonds are now on the rise
For an indication of the severity of the sell-off in emerging markets, look no further than the sharp declines in the prices of high-yield, or junk, bonds.
At the end of last year, dollar-denominated sub-investment grade corporate bonds in developing economies were all the rage, so much so that the gap, or spread, between the average yield of the high-yield component of JPMorgan’s benchmark Corporate Emerging Market Bonds Index (CEMBI) and its United States equivalent had fallen deep into negative territory. In other words, emerging market junk bonds were yielding less (and were therefore considered a safer bet) than speculative-grade American corporate debt.
Fast forward seven months, and the tide has turned. While US high-yield debt has proved remarkably resilient this year, emerging market junk bonds have sold sharply, driving the spread over US high-yield debt back into positive territory.
One of the main culprits behind the sell-off is Asia’s junk bond market, in particular the lowest-rated slices of Chinese corporate debt. Data from a report published by JPMorgan on Monday showed that spreads on Chinese bonds included in the high-yield component of the CEMBI have shot up more than 150 basis points in the past three months, double the increase for the broader high-yield index.
In a further illustration of the scale of the sell-off, the average yield on Chinese junk bonds in the index has surged 260 basis points since the start of this year, the sharpest increase among the leading emerging markets.
With junk bonds accounting for 43 per cent of the CEMBI, and China alone making up nearly a quarter of the index, emerging market corporate bonds have lost nearly 2 per cent so far this year, compared with gains of 8 per cent for the whole of 2017, according to JPMorgan.
The rout in China’s high-yield debt market stems partly from the slew of corporate defaults this year, both in the domestic market and offshore. In late May, China Energy Reserve & Chemicals Group, an oil and gas producer, defaulted on a US$350 million bond, triggering cross-defaults on four other of the company’s dollar-denominated notes. In the local market, Wintime Energy, a coal miner, defaulted on 11.4 billion yuan (US$1.7 billion) of debt earlier this month, the largest corporate default this year.
According to data from Bloomberg, 2018 will be China’s worst year ever for corporate defaults, exceeding the record of 20.7 billion yuan set in 2016.
The combination of a deleveraging campaign that has led to severe funding pressures, a deterioration in credit quality stemming from a slowing economy, and fears that a trade war will dent corporate cash flows have turned China’s high-yield bond market into one of the most vulnerable parts of the debt markets. In its report, JPMorgan warns that the sharp increase in defaults “could [yet] transform into a more systemic problem”, putting further strain on emerging market junk bonds.
Still, the sell-off has a number of silver linings.
The first is that the surge in bond defaults increases the scope for more market-driven pricing in China’s financial markets, potentially paving the way for a healthier and more mature debt market, provided regulators are willing to allow more vulnerable borrowers to fend for themselves.
Indeed, there are now more signs of complacency and price distortion in the US high-yield debt market, where spreads have fallen this year despite the sharp rise in volatility and the increasingly hawkish stance of the Federal Reserve.
The second silver lining, which runs counter to the first but is far more important from a market perspective, is that the financial and economic stresses that caused the defaults – and are also partly responsible for the sharp fall in the yuan and Chinese stocks – are now forcing policymakers to introduce measures to shore up growth as the trade war with the US escalates.
The decision on Monday to pump 502 billion yuan into the banking system and announce a package of tax cuts and infrastructure spending makes it clear to international investors that, when push comes to shove, the government can be relied on to stimulate demand – the so-called Beijing put.
China’s high-yield bonds have already bounced back. According to JPMorgan, the average yield on Chinese junk bonds included in the CEMBI fell nearly 40 basis points last week amid increasing signs that policymakers were preparing measures to boost growth. Not surprisingly, this triggered a sharp rally in Asian high-yield debt.
For investors in emerging market junk bonds, it pays to be a China expert.
Nicholas Spiro is a partner at Lauressa Advisory