Market watchers untroubled by China bond defaults

China market watchers are sanguine about the latest wave of bond defaults that started in the offshore market and have now spread to the domestic market.

Indeed, they say too few defaults were allowed to go through previously and the new wave is good for the system.

Defaults in the onshore bond market have only just begun in earnest, 34 years after the its reopening , with last week’s default on interest payments by central government-controlled Sinosteel attracting widespread interest.

Sinosteel last week postponed its interest payment on a 2 billion yuan (HK$2.43 billion) bond that fell due on Tuesday. The National Development and Reform Commission intervened on Monday to delay redemption of principal by a month to November.

A trickle of defaults in the offshore market, following one by property developer Kaisa earlier in the year, has seen new issuance stunted.

“We have seen investors come out of such deals with very little returns,” said Nigel Pridmore, a partner at law firm Ashurst. “The market for those companies really hasn’t been there, since Kaisa fell through. They [high-yield issuers] have not been able to get to market. Investors are nervy and just want to see what happens to Kaisa.”

Tao Dong, chief economist for non-Japan Asia at Credit Suisse, said: “the China bond market has rarely reported any defaults in its entire history, which is abnormal.”

Vijay Chander, executive director at ASIFMA, a regional, financial industry trade association, said investors in Kaisa’s high-yield bond knew what they were getting into.

“They were compensated,” he said. “They knew the risks going in. In earlier instances, with firms such as Asia Aluminium, investors had experienced high yield defaults. But the recovery rate was very limited. The risks were always there. If you were already an investor in China, you knew the game. They are mostly grown-ups. You can lose.”

At the end of the day, he said, there really was no protection.

Sure, you may have a keep-well deed, a standby letter of credit or equity purchase understanding,” Chander said. “But even those are untested. My bond – let’s say it’s issued out of a Singapore SPV [special purpose vehicle] – it’s all structurally subordinated to the mainland entity. Sure, SAFE [the State Administration of Foreign Exchange] may have allowed onshore entities to guarantee offshore issuance. But that’s in selective cases.

“If you’re an offshore investor, what would you expect of structural subordination? You have no access to the assets onshore – you are structurally subordinated to the onshore lenders. Even though the borrowing might be a senior issue, it’s still issued out of an offshore company,”

He said that with policymakers now mulling whether to give international investors expanded access to the domestic bond market, possibly via a bond connect scheme along the lines of the Shanghai-Hong Kong Stock Connect scheme, investors might see their standing improve.

“I already have this risk when I’m buying a dollar bond,” he said. “If I’m an international investor, and I’m buying this bond and I’m doing my credit work, it’s largely done on blind faith. The rating agencies – they can only go so far.

“But at least if I go onshore, I might get an onshore guarantee – because there’s some lien on onshore assets. I might be able to do some research and know which bank has something there. It’s much preferable to the existing approach.”

The State Council wants to bolster the bond market and use it as a means to break up the banks’ grip on total social financing. At last count, banks controlled 76 per cent of all outstanding financial assets on the mainland, with risks too concentrated for the cabinet’s liking.

Experts say the defaults that are finally trickling through are necessary pain the bond market must take if the central government is to realise its vision of a fully functioning market by 2020.

Too many bonds are still financed out of banks’ balance sheets. ASIFMA says bolstering secondary market trading by bringing in international investors and local long-term investors will help improve liquidity and market discipline.