Moody’s warns of more China bond defaults

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Record defaults last year have reduced investor demand for onshore Chinese bonds, according to Moody’s, yet funds prepare for inflows following the index inclusion.

China’s record-high RMB 84.3bn ($12.53bn) of onshore bond defaults in 2018 were driven mainly by companies’ poor liquidity. Nearly all (96%) of the companies had insufficient cash to cover their short-term debt (bonds and bank loans maturing in less than one year). And for 63% of the companies, short-term debt accounted for more than half of their total debt, noted Moody’s.

“Risk aversion [among investors], combined with higher funding costs and limited access to alternative funding channels makes it challenging for weaker companies to refinance, while the short tenors – often less than 270 days – mean they need to refinance frequently,” Nino Siu, a Moody’s senior analyst, said in a statement.


Characteristics of first-time defaulters in 2018

Insufficient cash to cover short-term debt

96%

High portion of short-term debt

63%

Debt/book capitalization > 50%

44%

Negative net profit

19%

Source: Moody’s Investors Services

The warning comes in the wake of Bloomberg’s decision to include Chinese government bonds in its widely-tracked BBGA index. At least $150bn of passive index-tracking money should flow into China’s bond markets during a 20-month phasing in period that started on 1 April.

Active investors will appreciate the diversification benefits of the market, as well as the high yields and low volatility compared with other government bond markets, HSBC’s fixed income investment director Gregory Suen told FSA in an interview last month.

However, these investors might be wary about allocating to lower-rated corporate bonds.

Companies with domestic ratings of AA or below are finding it more difficult to issue long-dated bonds in the onshore market, yet about RMB 4.5trn of  bonds issued by Chinese non-financial companies are set to mature in 2019, 66% of which were issued by weaker companies, according to Moody’s..

Poor investor demand has pushed credit and duration yield spreads wider and maturity dates are declining.

“We expect defaults will continue this year,” Moody’s said in the report.


Duration spread for weaker companies is fueled by onshore bond defaults

Source: Moody’s Investors Service

Alternative sources of funding are also drying up. It is difficult for weak Chinese companies to raise money in the shadow banking market as the government imposes tougher restrictions on the sector. In the offshore market, the tightening of global financial conditions has made refinancing harder since the second half of 2018.

Yet several China bond funds have performed strongly this year, riding the wave of broad investor confidence that has driven most equities and credit markets higher.

On the other hand, the three best performing funds over the past three years — managed by Income Partners, BEA Union Investment and BOCHK Investment Management — are predominantly invested in US dollar-denominated Chinese bonds, according to FE Analytics data.

In contrast, most of the holdings of the three worst performers are renminbi-denominated bonds.


Best and worst performing China renminbi bond funds

Source: FE Analytics. Three-year cumulative performance in US dollars.

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