So-called low-risk bonds, such as US Treasuries, once the bedrock of investment portfolios, are not providing the returns they once did. Photo: iStock

The draft guideline for post default treatment of bonds in China is grainy in detail but rich in its message – the authorities are keen on injecting credit risk into the financial system. And even though it is lacking in details, it will help in the development of a junk bond market very quickly, analysts say.

In December, China announced  draft rules on post-default treatment of bonds, a move that has been received positively by the market.

Bond defaults in China rose to a record 130 billion yuan in 2019 from less than one billion five years ago, according to S&P Global. This comes at a time when regulators declared there were over 580 banks in China that could be classified as high risk and that private enterprise bond default events should be dealt with in orderly fashion.

“The bankruptcy law is in early stages and there is no price discovery mechanism yet but the fact that PBOC is talking about distress and restructuring, it is a big deal,” said Jean-Charles Sambor, deputy head of  Emerging Markets Fixed Income at BNP Paribas Asset Management, referring to the central bank, People’s Bank of China.

“The regulator is trying to inject credit risk into the market without sparking systemic risk, which is why there is a grey area – to signal support,” Sambor added, explaining why there is no template for determining residual value or recovery on defaulted bonds.

“If they succeed in injecting credit risk into the market, we could see a junk bond market develop very quickly in the next 3-5 years.”

The defaults have risen as China’s growth pace fell to the slowest in nearly 30 years. Last year, GDP in the July-September quarter fell to 6%, the weakest growth rate since the first quarter of 1992. It is expected to end the year with an expansion rate of 5.9%, according to a Reuters poll – the weakest pace since 1990, as US tariffs will stay in place despite phase one of the trade agreement.

Washington will maintain 25% tariffs on $250 billion of Chinese imports and a 7.5% levy on another $120 billion.

GDP annual growth rate in China averaged 9.39% from 1989 until 2019. And defaults can only pick up from here as S&P Global expects the economy to slow further to 5.7% in 2020.

“It is a move in the positive direction but it ultimately boils down to implementation,” said Cindy Huang, analyst at S&P Global. “It is unclear if there are any legal implications or punitive consequences, since those details are lacking. What will it mean for companies that don’t follow these rules? How will they be treated? There are a lot of lingering questions. The fact that defaults are rising in itself is not alarming but what is of interest is what happens post default, whether the workout is transparent, fair and clearly communicated with investors.”

Bailout inevitable?

Before the defaults accelerated, spreads were tight and everything was priced top down. Investors were not looking at the entity credit risk but looking at them as if bailout were inevitable.

That is changing – the spread between AAA-rated companies, the strongest borrowers, and those rated AA, a notch below, has doubled to more than 300 basis points (bps) from 150 bps in 2017. This is much wider than the 100 bps differential in 2010, according to Fitch Ratings.

“We have seen from recent cases that the companies with unmanageable debt are starting to restructure. The wider spread between the AAA and AA credits would reflect ongoing credit differentiation, despite which inflows have stepped up in the past 2-3 years from foreign investors,” said Leonard Kwan, Emerging Markets Fixed Income Portfolio Manager at T. Rowe Price Group.

Globally, total emerging market and developing economies debt reached almost 170% of GDP in 2018 ($55 trillion), an increase of 54 percentage points of GDP since 2010, according to a World Bank report . China accounted for the bulk of this increase.

“The rise in debt in China has been focused in a few sectors, notably the real estate, mining, and construction sectors, and among state-owned enterprises,” the report said

And although there has been an acknowledgement of the default problems, there is much work to be done.

“The focus on post-default resolution also shows the government is increasingly willing to resolve distressed companies with market-based losses rather than unconditional bailouts. The draft guidelines, in our view, recognize the need to improve the post-default and recovery mechanism in China. However, the guidelines do not have specific legal implications and punitive consequences of non-compliance, raising questions over whether they’ll be followed,” said S&P Global analysts in a note.

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