When it comes to buying Chinese state-owned enterprises in the primary markets, bond investors have largely taken comfort in the idea that the central government will swoop in to save a strategically important quasi-sovereign from financial trouble by helping it pay off debt.
The assumed state backing has helped Chinese quasi-sovereigns obtain final credit ratings that often catapult them from speculative to investment grade — in some cases achieving as much as a five notch upgrade from their baseline rating.
The problem is that not only has this perceived state backing not yet been tested, but the degree of support could change as weaker economic growth and unconvincing profit growth among China’s mammoth SOE sector could prompt the Chinese leadership to force these state-run companies to become more financially disciplined.
And there is already some evidence that in times of stress SOEs are punished in secondary markets as investors start to doubt the strength of government.
Take for example Franshion Development, which is a state-supported Chinese property developer that issued $500m of 2021s in April 8, 2011. The split-rated notes, which were rated Ba1/BB/BBB, traded inside the average Asian BB curve on a 'Z' spread basis for a few months following the deal.
But in September 2011, during a wider sell-off in EM bonds, Franshion’s notes widened by more than 500bp on a 'Z' spread basis, in part due to investors discounting the government linkage even though the company’s fundamentals had not deteriorated.
While jumbo SOEs in key sectors, such as China Petrochemical Corporation (Sinopec) and China National Offshore Oil Corporation (CNOOC), are more or less immune to this phenomenon, this is an issue for less strategically important SOEs, where investors get jitters.
This is the reason investors should not consider buying a Chinese SOE simply based on its uplifted credit rating. When push comes to shove, it will be very difficult for China to support the estimated 145,000 SOEs in the country.
Much better would be to ask for premiums that take into account the unstable nature of government support and the ensuing volatility that accompanies bonds where there is a question over the government linkages, especially if SOE reforms could weaken that support in the future.
It’s about time investors got comfortable with a credit's baseline rating and its ability to generate cashflows even without support from the government. Because in the worse case, that investment grade bond could end up being no better than junk.