China’s bond investors are shying away from the riskiest companies, suggesting a summer lull in defaults is temporary.
The premium of five-year AA- medium-term debt over top- rated corporate notes has climbed to the highest level in four years, even as June saw just one default among publicly traded securities, the least since January. HFT Investment Management Co said delinquencies have become acceptable to the government as regulators step up efforts to start trading in credit-default swaps and improve bankruptcy laws.
“The strong push for credit-default swaps shows the curtain was just raised for credit events,” said He Qian, a portfolio manager who oversees almost 20bn yuan ($3bn) at HFT Investment. “It’s not over yet. Credit premiums will widen again.
There may be a lot more downgrades in July. Just a little bit of negative news from the issuer would lead to a selloff in its bonds.”
Defaults in China’s onshore market have almost tripled so far this year from the whole of 2015, leading to a rising number of pulled sales and a decline in net financing of corporate bonds to an all-time low in May. The world’s second-largest credit market faces a record 2.3tn yuan of non-financial firms’ debt due in the second half amid a faltering rebound in the economy.
China’s official manufacturing gauge retreated to the dividing line between expansion and contraction in June, while fixed-asset investments expanded at the slowest pace since 2000 in May. Industrial profit growth slowed, threatening to trigger more rating downgrades as companies release half-yearly financial reports.
Over the past 18 months, the credit quality of the 240 corporate and infrastructure companies that S&P Global Ratings grades has deteriorated steadily, with three times as many downgrades as upgrades. At the end of May, nearly a quarter of the portfolio had a negative bias, according to a June 21 report from the company.
“Poor earnings and cashflow would prevent credit premiums from narrowing,” said Tang Junjie, a fund manager at Wanjia Asset Management Co “Credit events may continue to occur frequently before the year-end, and credit premiums of certain industries are under pressure to widen further.”
The yield gap between five-year AA- medium-term notes and top-rated ones climbed to 277 basis points on June 29, the widest since March 2012. Seventeen publicly-traded bonds defaulted in the first half of this year including Sichuan Coal Industry Group LLC’s one-year bills last month. Debt rated AA- or lower is considered junk in China’s onshore market. Guangxi Materials Group Co’s June 2017 note fell 2.5% in the second quarter, while Inner Mongolia North Heavy Industry Co’s February 2017 note declined 1%. Both are rated AA- by China Chengxin Ratings.
Credit-default swaps ensuring China’s sovereign debt against non-payment have risen 32 basis points to 125 in the past year.
“Demand is very weak for debt issued by companies in overcapacity industries or those that are poorly-graded,” said Li Huaijun, chief analyst at First Capital Securities Co. “The risks in corporate bonds haven’t been fully exposed yet.” The National Association of Financial Market Institutional Investors held a meeting at the end of May, at which some market participants voted to pass proposed rules for credit-default swaps, according to people familiar with the matter.
Non-financial companies listed in Shanghai or Shenzhen have generated operating earnings 2.3 times their interest payment, based on their latest filings, down from 5.2 times five years ago. The firms’ aggregate total debt rose 80% to $1.5tn over the period, according to Bloomberg-compiled data.
A survey conducted by Bloomberg News at the end of last month had 18 of 22 respondents forecasting more defaults in the third quarter than the total so far this year, while 14 said they’re most bullish on sovereign or quasi-sovereign debt among all types of fixed-income products.
“The pricing difference between top-rated companies and those of the poorest quality will widen further,” said HFT Investment’s He. “Investors have become increasingly unwilling to buy bonds issued at high yields, as that only put the companies under heavy burden for debt servicing.”