The record number of corporate defaults in China has improved risk pricing in the world’s third largest bond market. Despite this, Chinese corporate bonds have a long way to go to attract foreign investment.
“This year, there is a very obvious improvement in risk pricing in the risk premium in the onshore and offshore markets of Chinese issuers,” said Iris Pang, greater China economist of ING Bank.
“In the past, the credit spread between low quality corporate credit compared with moderate credit risk was very low in the Chinese onshore market. Now it has widened, which reflects a higher premium. The improvement is quite substantial,” Pang said.
On December 10 for instance, the yield for 3-month AAA rated Chinese corporate bonds was 3.14%, compared to a 3-month A rating of 9.49%, according to state-owned securities depositary China Central Depositary & Clearing (CCDC). In comparison, on March 16, the yield for 3-month AAA rated Chinese corporate bonds was 4.78%, while that of 3-month A rated bonds was 9.57%. This means that the spread between AAA paper and A rated paper had widened 156 basis points between March and December.
The widening credit spread in Chinese onshore corporate bonds will provide more trading opportunities for investors and attract more investment. On the other hand, investment sentiment in corporate bonds may be dampened by the corporate default cases.”
“I think that foreign investment will continue to focus on treasury and policy bank bonds. They may also be interested in bonds issued by large SOEs [state-owned enterprise] that are considered low risk,” said Ivan Chung, head of greater China credit research and analysis at Moody’s.
In November, more than 90% of foreign investment’ in Chinese bonds was concentrated in policy bonds, negotiated certificates of deposit and treasury bonds, according to Bond Connect, a platform that enables international investors to use Hong Kong to trade bonds in mainland China.
But some think that it will take a while before foreign investment in Chinese corporate bonds hits prime time.
"Despite recent credit events, onshore spreads still feel suppressed. In light of this, we do not expect to see a material uptick in interest in onshore corporate bonds on the part of international investors. With non-SOE onshore AA-rated bonds priced at around 8% against 10% offered by offshore high-yield bonds, the spread is simply not rich enough," said Tim Galt, the Asia head of debt capital markets syndicate at UBS.
"With the exception of marquee names like CNPC and CNOOC [two large Chinese state-owned oil companies], liquidity in the secondary market is extremely thin. Onshore investors tend to buy and hold with leverage, and in the absence of a fully developed infrastructure for dealing with bankruptcy, investor feedback is that some find it difficult to arrive at a price for perceived default risks,” he added.
"At the same time, covenants are not yet standardized and prospectuses are in the Chinese language which makes credit analysis difficult," Galt said.
Another obstacle to foreign investment is a lack of sophisticated hedging instruments in China. Offshore investors would love to have access to instruments to hedge credit risk before they put more money into Chinese corporate bonds.
Offshore investors tend to invest in government bonds and policy bank bonds, due to their preference for lower risk. Nonetheless, better pricing of risk would encourage offshore investors to invest in onshore lower-rated bonds in China, given the better risk-return.
DEFAULTS
The marked improvement in risk pricing is due to the historical record level of corporate defaults in China this year. For 2018 to date, 110 corporate bonds totalling Rmb109.7 billion ($15.9 billion) have defaulted. This is more than three times the 35 corporate bonds totalling Rmb33.7 billion for the whole of 2017. and around double the 56 corporate bonds totalling Rmb39.4 billion in 2016, according to Chinese financial information provider Wind. Private companies accounted for almost three-quarters of these defaults.
Nonetheless, China’s default rate - 0.3% to 0.5% - is low by global standards which are typically 2% to 2.5%.
High default rates, in allowing companies to fail, is good for the development of the bond market in the long term. “That will facilitate more efficient and effective pricing of risk,” said Angus To, deputy head of research at ICBC International Research.
Less competitive enterprises will pay a higher premium in funding, while better companies will have lower funding costs. “With improved risk pricing, investors can make a more discerning choice of companies, because funding costs better reflect fundamentals,” he explained.
In the past, the market thought there would be an implicit guarantee for corporate bonds from the Chinese government. “The higher number of defaults in China this year shows this market perception is no longer valid. The Chinese government is letting market forces play a bigger role,” To added.
Next year, China’s corporate default rate could remain around the same as this year or even rise modestly as the country continues to deleverage. Companies vulnerable to defaults include lower rated corporates in sectors with excess supply such as commodities as well as those with relatively high leverage.
There are now more local and foreign players in China’s onshore market. “Now that we have more foreign investors in China’s onshore debt market, that facilitates better pricing. Foreign investors demand pricing to reflect the true risk,” ING Bank's Pang said.
Foreign holdings of Chinese bonds have doubled to Rmb1.68 trillion in October from Rmb843 billion in June 2017, according to Bond Connect. The sharp rise in foreign holdings of Chinese bonds is largely due to the opening of Bond Connect in July last year.
But foreign ownership of China’s $12 trillion bond market, the world’s third largest after Japan and the US, remains tiny. According to the People’s Bank of China, foreign holdings in the domestic bond market account for only 2.4%. This is far lower than the average of 20% in developed markets, and lower than the 10% in developing countries.
“With the continuous opening of China's bond market and the continuous improvement of infrastructure, in the long run, the participation of foreign investors will significantly improve,” said ICBC International in a report at the end of November.
