Surging defaults doing little to dampen appetite for bonds

Some suggest the main reason is Beijing’s largely failed efforts so far, to end what economists call China’s ‘rigid payment’ mindset

PUBLISHED : Monday, 15 August, 2016, 7:08pm
UPDATED : Monday, 15 August, 2016, 10:15pm

Despite a rise in Chinese bond defaults in the first six months of the year, new issuance has surged over the same period, as a result of excessive liquidity in the market.

The conflicting situation, is put down to a mix of factors.

But arguably most worrying, say experts, is that much of the appeal to still buy bonds is being driven by the ongoing belief the Chinese government is likely to step in and bail out issuing companies if they get into trouble and default – a perception Beijing has been working hard to extinguish.

Since the start of the year, according to data from Wind Information, there have been 40 default cases, more than the previous two years combined.

The value of those was in excess of 20 billion yuan, more than double the amount for the whole year of 2015.

Within those figures, state-owned enterprises and local government-owned firms accounted for about 60 per cent of the cases, in contrast to last year, when 80 per cent of defaults were by private companies, according to Wind Information.

The data shows, too, that even those companies that haven’t defaulted are also under pressure from the ratings agencies, with more than 100 firms downgraded so far this year.

Experts now say more defaults are inevitable in the domestic bond market, as the slowing economy squeezes profits.

A rise in cases might naturally mean a fall in the number of new issuances – but that’s proving far from the case in China.

Even with those tougher conditions, firms remain keen on issuing bonds, and investors remain unconcerned enough by the possible losses not to invest in them.

According to data from the People’s Bank of China, bond issuance more than doubled year-on-year in the first half of this year, surging by 110.2 per cent compared with a year ago, to 18 trillion yuan.

By the end of June, the total amount of outstanding bonds had reached 57.4 trillion yuan, rising 44 per cent compared with the same period last year.

Hong Hao, managing director and chief strategist at the Bocom International in Hong Kong, said the ongoing market enthusiasm for bonds is partly explained by record low yields being offered, encouraging more companies to raise money through bonds.

He pointed out, however, that the excessive liquidity and declining yields on government bonds, means yields on corporate bonds have also been falling.

As of August 12, the yield on a 10-year government bond had dropped to 2.66 per cent, the lowest level since 2006. The yields on corporate bonds has been pushed down to 5-6 per cent from the 12 per cent previously seen, said Fan Wei, the chief fixed-income analyst at Shenwan Hongyuan Securities.

But arguably what is the strongest influence on the current surge in new bonds, comes down to the mindset the government is unlikely to tolerate further widespread defaults, meaning bonds are still effectively seen as safe, despite the rise in default cases — what economists call the “rigid payment” mindset.

This no-default psyche has long been viewed as a major problem for China’s bond market, and the government has pledged a “decisive role” in smashing the expectation.

For years, Chinese bond defaults were unheard of in the domestic market, with the government reliably stepping in to bail out troubled issuers.

Some economists consider that corporate bond defaults would actually help the long-term development of China’s debt market because they would reduce moral hazard caused by the widespread assumption of endless government funds to prop up the market.

Many were encouraged in March this year, when Premier Li Keqiang said the government would only prevent a systemic collapse, and individual cases of financial default would be allowed to run their course.

Another factor, Hong said is the current narrow spread between yields on bonds issued by companies with higher (credit) ratings and lower ratings is a further factor encouraging investors into the market, as is the need to meet portfolio allocation requirements, amid a market short of good investment options.

Normally, investors expect lower yields on bonds issued by companies with higher credit ratings and higher yields on bonds issued by firms with low credit rating.

“The narrowing of the two means many investors are also becoming less worried about the varying risk involved in either ‘bad’ or ‘good’ companies,’ said Hong Hao.

“That could be taken as a sign that bond investors still maintain a rigid payment mindset, and firmly believe the government will not tolerate any substantial defaults,” added Hong.