Defaults Worsen Bias Against Private Bond Issuers: China Credit

Apr 09, 2014 1:02 am ET

April 9 (Bloomberg) -- China’s first default is prompting investors to discriminate against privately-owned companies, boosting demand for local government bonds even as the central bank warns of the dangers of a $2.9 trillion pile of debt.

The yield on Tieling Public Assets Investment and Management Co.’s seven-year notes plunged 117 basis points this year to 6.72 percent and Changxing County Transportation Construction Investment Co.’s debt also rallied, exchange data show. The average yield on 2021 debt rated AA fell seven basis points this year to 7.55 percent yesterday, while that for notes ranked A climbed 12 basis points to 11.67 percent.

Premier Li Keqiang said last month that failures of financial products are “unavoidable,” a week after a solar company whose controlling shareholder is the chairman became the first Chinese issuer to default on its onshore notes. Risks of nonpayment have climbed as economic growth slows after a five- year credit binge. Li said there would be no “regional financial risks,” prompting investors to bet the state would stand behind local-government financing vehicles.

“After the credit event, fund allocation has become less efficient and more biased toward government-related industries,” said Xu Gao, a Beijing-based economist at Everbright Securities Co. “Investors have pushed up the risk premium, but as they believe that LGFVs have government support, the higher risk premium has only appeared in private companies’ bonds.”

First Default

Shanghai Chaori Solar Energy Science & Technology Co. failed to make a full 89.8 million yuan ($14.5 million) coupon payment in March, marking China’s first onshore corporate default. Two months earlier, a 3 billion yuan trust product distributed by the nation’s biggest bank came close to nonpayment before a partial bailout. Corporate credit spreads are likely to widen further amid signs trust funds and company debt aren’t guaranteed by the government, DBS Group Holdings Ltd. said in a report yesterday.

Among private companies, the yield on ZTE Holding Co.’s eight-year bonds rated AA+ rose 80 basis points this year to 6.60 percent yesterday, exchange data show, while that on Sinovel Wind Group Co.’s AA 2016 securities jumped 274 basis points to 12.47 percent.

Regional authorities, which aren’t allowed to sell debt directly, have set up thousands of financing vehicles to raise funds to build subways, highways and sewage works. Local governments are responsible for 80 percent of spending while they get only about 40 percent of tax revenue, the legacy of a 1994 tax-sharing system, according to the World Bank.

Rising Liabilities

A 2008 stimulus package deployed amid the financial crisis and funded with off-balance sheet lending added to the debt burden for local governments. Their liabilities rose to 17.9 trillion yuan as of June 2013 from 10.7 trillion yuan at the end of 2010, according to National Audit Office data.

LGFVs were among the three riskiest types of debt highlighted by the People’s Bank of China in its fourth-quarter policy report. Their debt is headed for a “mini crisis” because defaults will be needed for restructuring, Li Daokui, a former adviser to the central bank, said March 25.

“Policy makers would like to warn markets so LGFVs may restrain their borrowing, but the threat isn’t fully credible,” said Alica Garcia-Herrero, chief economist for emerging markets at Banco Bilbao Vizcaya Argentaria SA in Hong Kong. “Investors that bought corporate bonds now know a default is much likelier on that side and are substituting them with LGFV bonds.”

Fiscal Reforms

Any LGFV defaults will have to be part of broader fiscal reforms, said Garcia-Herrero. As policy makers are probably more sensitive to the risk of social instability than they are to the dangers of financial and fiscal indiscipline, there will be no LGFV defaults in 2014, Standard & Poor’s said Jan. 24.

A report by Moody’s Investors Service in November said only 53 percent of the 388 LGFVs it surveyed in June had enough cash to cover estimated payments and interest last year without refinancing. About 66 percent of their cash expenditure was for repaying principal and interest in 2012, according to data from China Chengxin International, a Moody’s joint venture.

LGFV bonds were supported by ample cash supply. The benchmark seven-day repurchase rate plunged 87 basis points in the past six months to 3.63 percent yesterday. The central bank is easing monetary policy after industrial output, investment and retail sales grew slower than estimated in the first two months of the year. The yuan declined 2.3 percent this year to 6.1948 as of 11:28 a.m. in Shanghai, China Foreign Exchange Trading System prices show.

Liquidity Conditions

“LGFV bonds are more affected by liquidity conditions as they depend on refinancing to support bond prices,” said Qiu Xinhong, a Guangzhou-based fund manager at Golden Eagle Asset Management Co. “Their cash flows are terrible. The return on assets is far lower than interest rates, so that shows there’s external support, which is government support.”

Five-year AA rated corporate bonds offer a 306-basis point premium over sovereign notes, up from 231 a year earlier. Heilongjiang Hecheng Construction Investment Development Co.’s seven-year bonds traded at a yield of 7.26 percent, while the yield on similar maturity government securities is 4.40 percent.

The high yields on the bonds show the state guarantee is “vague” for any notes other than those issued by policy banks and state-owned enterprises directed by the central government, according to Becky Liu, a Hong Kong-based rates strategist at Standard Chartered Plc.

Regulated Borrowing

Premier Li told the National People’s Congress last month that China will develop a regulated regional borrowing mechanism and include local liabilities in its fiscal budget. The Ministry of Finance said it will sell 400 billion yuan of debt this year on behalf of regions and maintain municipal-bond market trials, with the ultimate goal of removing the government financing function from LGFVs.

While increasing default risks have boosted demand for LGFV debt, it has become harder for private companies to raise cash this year. Corporate bond sales shrank 39 percent and the government curtailed shadow banking, or off-balance-sheet lending. Higher borrowing costs may hamper Premier Li’s quest to bolster smaller enterprises as part of a plan to boost the role of market forces in the economy.

The top three corporate issuers last year were all state- owned firms, with China Railway Corp. accounting for 13 percent of total sales. Smaller firms, many of which are rated A, mostly rely on the private placement market or commercial paper, according to Guotai Junan Securities Co., the nation’s third- biggest brokerage.

Private Companies

“Many private companies can’t issue bonds now, no matter how high coupon rates are,” said Qiu at Golden Eagle Asset Management. “Of course, they were never the main force in China’s debt markets.”

The yields on LGFV bonds will continue to fall relative to private companies of the same rating, said Xu at Everbright Securities. China International Capital Corp., in a March 31 report, recommended local government securities for investors looking for higher yields in the second quarter, noting that the premium on such debt reflects liquidity risks rather than credit dangers. Refinancing channels for LGFVs won’t tighten in the short term as policy makers still want to curb regional systemic risks, the investment bank said.

“I think the government probably believes in the mantra” of pricing bonds based on their credit risks, said Garcia- Herrero at BBVA. “But are they ready to pay the price? Not yet. That’s why yields show what they show.”

--With assistance from Xin Zhou in Beijing.