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China economy

China bond defaults tripled in 2018 – the case of one property developer shows why

  • Corporate bond default cases surged to 119 in 2018 from 35 in 2017 while defaulted bond value tripled amid a trade war with the United States
  • Default of private property developer Yinyi Co Ltd showcases troubles of China bond issuers
PUBLISHED : Monday, 31 December, 2018, 4:36pm
UPDATED : Monday, 31 December, 2018, 4:43pm

The year 2018 witnessed an unprecedented wave of corporate bond defaults in China, as the world’s second biggest economy lost steam amid a trade war with the United States.

The expectation that the economy will slow further, combined with the government’s continued efforts to rein in debt and risky lending, suggest the number of defaults is likely to increase further next year.

The number of corporate bond default cases surged to 119 in 2018, or more than triple the 35 cases in 2017, while the value of defaulted bonds also tripled to 116.6 billion yuan (US$16.95 million) in 2018 from 33.7 billion yuan (US$4.90 million) in 2017, according to the data compiled by Wind Information, a Chinese financial data provider.

While the defaulted issues represent only a small fraction of onshore bonds in China, the rapid pickup in defaults is exposing deep strains in the country’s debt-fuelled growth model of the last decade.

China’s property sector, which lies at the centre of the construction and development boom, had accumulated debts, including bank loans, trust loans and bonds, of 15.6 trillion yuan (US$2.27 trillion) as of June 2018, more than double the 7.6 trillion yuan three and half years ago, according to Lu Ting, China chief economist at Nomura.

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As China’s economic growth slowed and the government’s deleveraging campaign made lenders cautious about extending more credit, many property developers have struggled to repay debts.

“Some developers could find themselves short of the funding needed to deliver new homes on time,” Lu said.

Yinyi Co Ltd, a property developer in the Chinese port city of Ningbo, is the latest property developer to default on its bonds.

Yinyi said last week that it could not pay to redeem the 300 million yuan (US$43.62 million) due on bonds issued three years ago because of short term liquidity problems. The five-year bond had a put option allowing bondholders to request repayment at the end of the third year.

In an attempt to avoid early redemption, Yinyi sweetened the bond’s annual coupon rate by 150 basis points to 8.78 per cent from 7.28 per cent, but investors still demanded that Yinyi repay their debts.

“If the company cannot properly resolve its overdue debt problems, it will face further lawsuits, with bank accounts being frozen, assets frozen, and may also need to pay related default damages, late fees and penalties,” Yinyi said in a filing with the Shenzhen Stock Exchange, where it is listed.

“This will affect the company’s operations and business, further increase financial costs and affect the company’s performance for the current year.”

Like many other home builders, Yinyi’s billionaire chairman Xiong Xuqiang has been seeking to diversify the company’s operations since 2016, in the face of slower economic growth.

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Xiong Xuqiang made three overseas acquisitions for a combined 13 billion yuan (US$1.89 billion) to transform the company into an automotive parts supplier.

His diversification strategy followed similar moves employed by other real estate tycoons, including Hui Wing Mau of Shimao Property and Hui Kai Yan of Evergrande Group.

But the transformation process actually backfired because of shifting external circumstances and Yinyi’s aggressive overseas investments, along with shrinking demand for auto parts due to a weakening car sector, drained the company’s liquidity and eventually triggered its bond default, analysts said.

“It’s not difficult to see cases in the past when aggressive investments triggered bond defaults,” Guotai Junan Securities said in a research note. “A rushed transformation when sentiment is weakening often brings a company more risks than opportunities.”

Yinyi, which this year acquired Japan’s Nippon Aleph Group, a maker of sensing and switching components, had suspended trading of its shares in mid-August for what it said was an asset restructuring.

The China Securities Regulator Commission forced Yinyi to resume trading last month after a three-month suspension as the stock regulator sought to rein in protracted trading halts used by companies to shield their stocks from sharp price declines.

Reports of Yinyi’s liquidity crunch and its forced stock resumption prompted investors to scrutinise the company even more closely, Guotai Junan said.

Eight of Yinyi’s top 10 shareholders, including Xiong Xuqiang’s son Xiong Jikai, Ningbo Shengzhou Investment and Tibet Yinyi Investment Management, accounted for 79.09 per cent of the company’s total shares, of which 93.62 per cent were pledged as loan collateral.

Yinyi disclosed that eight pledges between five financial institutions and Xiong had constituted a breach of contract.

Shares in Yinyi plummeted 72 per cent from its May peak of 11 yuan (US$1.60) to 3.12 at Friday’s close, as the controlling shareholders cut their holdings.

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China Chengxin Credit Rating downgraded Yinyi’s credit and debt ratings to C from BBB on Tuesday, the second downgrade in a month, and the company remains on Chengxin’s negative outlook watch list. Yinyi’s credit and debt ratings had been cut to BBB from A earlier in December.

Yinyi’s bond default and other cases involving property developers that have emerged this year mark a sharp break in the industry’s zero default rate of the past.

This year saw the first bond defaults in the property sector with six, worth a total of 4.67 billion yuan (US$678.96 million), according to Wind Information.

No Chinese company had ever defaulted on a corporate bond before 2014 as repayments were always protected by implicit guarantees where investors did not assume losses.

As long as the implicit guarantees held, investors preferred high-yielding corporate issues, increasing hidden risks in the financial system.

The number of corporate bond default cases began to rise gradually in 2014, with six cases worth 1.34 billion yuan (US$194.82 million), rising to 35 cases worth 33.7 billion yuan (US$4.90 billion) in 2017 and to 119 cases valued at 116.6 billion yuan (US$16.95 billion) this year, Wind Information data showed.

Yinyi’s default, along with Zhonghong Holdings, the Beijing-based real estate developer controlled by tycoon Wang Yonghong with total overdue obligations of 2.27 billion yuan, suggest the government is continuing its efforts to reduce implicit guarantees and so reduce moral hazard as part of its overall campaign to reduce risks in the country’s financial system.

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The process will help investors to finally distinguish between different levels of corporate risk across a spectrum of strong and weak borrowers.

Understanding the credit risk and default patterns in China is especially important for policymakers and investment professionals as China opens its debt market to foreign investors.

As property sector growth has slowed, Chinese policymakers have taken some easing steps, such as a moderately reducing mortgage loan interest rates in some large cities.

Policies were also introduced to support big developers’ bond financing while local governments were awarded the power to make their own property market policies based on local conditions.

While company defaults are likely to continue to rise in 2019, the government’s easing policies will keep China’s overall default rates at a relatively low level, analysts said.

“The default rates on Chinese high yield [bonds] are likely to remain low and should continue to be below US and European high yields in the next six to 12 months,” said Bryan Collins, head of Asian fixed income at Fidelity International.

However, Collins warned that smaller, low-rated companies with near-term refinancing requirements, limited capital market experience and few funding channels, are still likely to be tested.

Smaller and weaker companies will be under heavy pressure from the tidal wave of debt issues that will mature over the next two years.

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Around US$29 billion of sub-investment grade and unrated bonds will mature in the offshore market in 2019, followed by further US$40 billion in 2020, according to Bloomberg data.

The ability of top players to continue selling homes in the weakening economic environment far outweigh the rest of the industry, and support their financial health. Given the problems faced by smaller developers, large firms can continue to grab market share with their diversification tactics.

Expansion by smaller home builders will remain limited, especially highly-leveraged firms that are constrained by their lack of capital, adding to default risks.

“In particular, those rated B or below are likely to face credit pressure,” said Su Aik Lim, senior director and head of China property ratings at Fitch Ratings, adding that he expected overall housing sales volume to drop by 5 to 10 per cent in 2019, which would lead to a steep drop in profits and revenue.