According to Lau, there have been 25 onshore bond defaults in China year-to-date.
“The Chinese government has allowed defaults for China’s onshore bonds issued by state-owned enterprises. I don’t see why this won’t happen for the offshore bonds issued by the SOEs as well,” Lau told FSA.
Bond defaults in China have become a top concern among foreign investors. China has had more corporate bond defaults so far in 2016 than all of last year, FSA reported earlier.
BNP Pariabas Investment Partners believes that as an asset class, China’s fixed income is undergoing significant changes, as the Chinese authorities pull away from an implicit promise to protect investors from bond defaults.
Despite the concerns on bond defaults, Vanguard Investments in Hong Kong believes that the Chinese policymakers are capable of preventing a credit crisis from happening in the country.
Risks from LGFVs
Beijing’s approach has been to swap corporate obligations into government debt, but in recent years, the Chinese government has undertaken various financial reforms, including limiting debt issuance by local government financing vehicles, or the LGFVs.
LGFVs are entities set up by local governments to raise funds primarily for costly infrastructure and real estate development projects. The business models of the LGFVs are more like implementing policy projects, so they do not have operating assets and they are mainly supported by the government, Lau said.
These companies have long been flagged as key source of risk to the Chinese banking system.
In 2014, China put limits on LGFVs for raising funds on behalf of the local governments. As a result, some LGFVs have had difficulty tapping the local banking and onshore bond markets to fund their operations.
“Certainly we should expect more LGFVs to tap not just the onshore bond market, but also the offshore bond market,” Lau said.
He believes that offshore bonds should have some re-pricing mechanisms.
“If the Chinese government allows onshore bond defaults, why shouldn’t offshore bonds have re-pricing mechanisms? Even some offshore bonds issued by LGFVs are classiified as investment grade, but they are not trading at investment grade spreads but high yield spreads.”
On and offshore
For Chinese offshore products, Lau said he does not favour sectors such as securities, as the sector has a negative earnings outlook due to higher volatility in both China and offshore stock markets.
In terms of domestic bonds, Lau believes those issued by “old economy” sectors, such as coal, copper and cement come with particularly high risks, given the negative outlook on their business operations due to an economic slowdown in China.
“These onshore bonds are pricey and have not reflected their operational risks.”