Making sense of China bond market defaults

Key takeaways

• China is allowing more debt defaults, but in a controlled manner. State-owned enterprise (SOE) defaults should mostly come from those with low strategical importance or weak fundamentals. 
• China aims to promote market-oriented debt resolutions for SOEs. 
• A new three-year reform program should play a vital role in developing the onshore bond market.
• In our view, China's offshore U.S. dollar bond default risk is manageable.
• Recent funding curbs on China’s property developers aim to manage housing market risk.
• Proprietary research can fill the information gap, providing investors with additional details on each issuer.

Despite the recent increase in credit events, we believe the case for investing in Chinese corporate bonds remains strong, with the search-for-yield theme still very much in play. We acknowledge the issue of Chinese corporate debt defaults, but in our view, with careful credit selection, the country’s credit market can remain a good opportunity for investors. China’s economic and demonstrated market resilience—with a spread premium over developed bond markets—places it in a unique global position.

China U.S. dollar credit can offer a spread pickup versus U.S. corporate bonds

The big picture: recent credit events and the continuing credit cleanup

During the first half of 2021, we saw an increasing number of onshore and offshore credit events, with the number of year-to-date onshore bond defaults already exceeding 50% of the full-year total for 2020.¹ Instead of kicking the can down the road, we believe the Chinese government is allowing more debt defaults in a controlled manner as a continuation of the credit cleanup that has been taking place over the past few years. We think this approach is positive for the financial health of the corporate sector, especially property and SOEs. Policymakers now have a higher tolerance for defaults amid the sustained recovery in China’s economy that has materialized since the second quarter of 2020. Also, we see an increasing willingness to let creditors bear associated losses, which represents a shift from the prior belief that the government would bail out bondholders of failed financial institutions. More market-driven and orderly defaults should lead to credit risk pricing that is more reflective of credit fundamentals.

While these defaults may lead to market jitters and a widening of credit spreads, our base case is that SOE defaults will likely be seen among those with low strategical importance or weak fundamentals and may not cause systemic risk.² In our view, the recent trend of large and high-profile SOE defaults highlights the importance of fundamental credit analysis and credit selection, especially in the China onshore bond market where there’ limited credit differentiation and government support is taken for granted. 

SOE reforms amid rising onshore defaults

While market dynamics are resulting in a healthier and more sustainable credit environment, government reform also plays an increasingly indispensable role in developing the onshore bond market. In June 2020, President Xi Jinping approved a new three-year reform program,³ a development that has kick-started a new round of mergers and asset restructuring among central and local level SOEs in areas such as steel and the infrastructure space. In summary, the program is designed to help SOEs become more competitive and market-driven while solidifying the central government’s influence on SOEs and, in turn, enhancing SOEs’ influence in those strategic industries aiming to achieve national goals (e.g., carbon neutrality by 2060).⁴

Issuers’ total notional amount of onshore bonds outstanding at the time of default, as a percentage of total corporate bonds outstanding at the start of the year

Source: Goldman Sachs, June 25, 2021.

As the COVID-19 situation in China has stabilized and the economy is broadly recovering, onshore defaults could pick up moderately. Based on the latest guidance, the central government aims to promote more market-oriented debt resolutions for SOEs, with a greater tolerance for insolvent local government financing vehicles (LGFVs) to default. While we expect the process to be gradual, we believe that the so-called zombie SOEs and LGFVs could be default candidates. Zombie attributes include very weak fundamental profiles, limited strategic functions, and exposure to highly polluting industries such as coal mining. Having said that, with an overall default rate of less than 1%,⁵ SOE default risk should remain manageable given the efforts by local government to smooth the process without causing a systemic impact on local funding channels. We believe there are more opportunities in SOE issuers—particularly those with sound credit profiles, consistent financial policy, and the ability to ride through cycles with manageable fallen angel risk. Also, we believe issuers with clear strategic importance will warrant government support to offset any fundamental weakness arising from their policy function.

Amid the post-COVID-19 recovery, we expect an improving operating environment, and the broad price recovery in commodities should alleviate some of the pressure on privately owned enterprises (POEs). Since the weaker POEs have already defaulted, we believe that the default rate should moderate from the record high witnessed in 2019.

Offshore credits: policy tightening may lead to consolidation for property developers 

Overall, we think the default risk in China’s offshore U.S. dollar bond market is manageable, as China’s offshore high-yield (HY) market is dominated by local property developers.⁶ As the Chinese government continues with its more proactive approach to managing systematic risk in the sector, we don’t expect sharp credit deterioration or widespread defaults. Given the significance of the property sector in terms of its contribution to the economy and its role as a store of wealth, we believe it’s in China’s interest to promote healthy and sustainable development within the sector instead of adopting an abrupt intervention that could lead to sharp price corrections and a drastic surge in defaults. In fact, we’re already seeing some uptick in single B-rated⁷ developer defaults. 

China G3 HY bond market default rate (weighted by outstanding amount)

Source: Goldman Sachs, as of June 17, 2021.

The recent funding curbs on China’s property developers aim to manage risk in the housing market, which is showing signs of overheating. This approach, essentially a form of policy tightening, will inevitably lead to challenges for weaker developers with limited access to funding and financial flexibility. That said, we expect the overall default risk in the sector to be manageable. Under the People’s Bank of China’s three red lines rule,⁸ developers with excessive leverage will come under pressure to slow their pace of expansion and focus on improving the quality of their growth, which we think may improve their credit profiles over time. Furthermore, we believe that larger developers with financial flexibility and access to funding should play a greater role in the industry’s consolidation over the coming years. We believe this would lead to further polarization within the sector and accelerate consolidation over the medium to long term.

We believe that developers with decent scale and financial strength to buffer the ride through various market cycles should stand out. These companies tend to have ample land reserves either nationally or in major economic clusters where they hold leading market positions. In addition, developers with access to diversified funding channels in both the onshore and offshore markets should be in an advantageous position. In our view, this is critical to a developer’s liquidity position as well as its long-term success. 

The importance of both onshore and offshore research presence

China’s credit market is the world’s second largest and one that’s still growing.⁹ As China’s onshore and offshore bond markets continue to develop, the information gap in these markets becomes more noticeable. At Manulife Investment Management, we take pride in our bottom-up fundamental research capabilities, with both onshore and offshore research presence, including dedicated credit analysts in Shanghai and Beijing. When assessing the creditworthiness of a local or central SOE, we believe it’s essential to understand the entity’s role in the eyes of either local or national government, and their access to onshore and offshore funding. Often, developments in the onshore market could be verified through our team’s offshore presence, and vice versa, to understand the relevant nuances. Having both an onshore and offshore presence with access to on-the-ground intelligence, therefore, fills the information gap by providing us with an additional layer of detail on the quality of each issuer. Ultimately, this market knowledge helps us identify attractive opportunities for our investors.

1 Goldman Sachs, June 21, 2021. 2 So far, the default rate of SOEs in China remains below 1% (of total China onshore corporate bonds outstanding), which is a level that’s low compared with other bond markets around the world. Chinese authorities have shown in the past that they’re willing to take bold measures to support and restore confidence in the market to prevent any contagion risk.  3 “SOE reforms to drive economic development,” China Daily, June 5, 2020. Premier Li Keqiang delivered the government work report on May 22, 2020, in which it was announced that China will launch a three-year action plan for SOE reform, improve the system of state capital regulation, and intensify mixed ownership reform of SOEs. 4 “China pledges to be “carbon neutral” by 2060,” Financial Times, September 23, 2020. 5 Goldman Sachs, June 25, 2021.  6 These make up about 46% of the J.P. Morgan Asia Credit Index (JACI) China high-yield segment. 7 Single B-rated debt instruments are widely considered to be speculative in nature and carry high credit risk. 8 The People’s Bank of China and the Ministry of Housing announced in 2020 that they had drafted new financing rules for real estate companies. Developers wanting to refinance are being assessed against three thresholds: a 70% ceiling on liabilities to assets (excluding advance proceeds from projects sold on contract), a 100% cap on net debt to equity, and a cash to short-term borrowing ratio of at least one. 9 Bank of International Settlements, June 23, 2021.