Senior officials within the China Securities Regulatory Commission (CSRC) have publically warned mainland investors of the risks associated with investing in the country’s nascent high yield bond market, stating that the government cannot be counted on to bail companies out of debt in the event of a default.
Yet, in a market that has not seen any company default on its bonds – and is therefore unaccustomed to the protocol if a default occurs – capital market insiders are sceptical that China has seen the last bailout of troubled debt issuers.
“It remains to be seen whether the government will or will not bail out issuers, but given the history that there hasn’t been a default in the bond market, it’s likely we’ll still see more bailouts,” said Ivan Chung, senior credit analyst at Moody’s. “Nobody will say ‘bailout’ though because it creates a big moral hazard problem. But a bailout will depend on the market situation, whether there’s political stability and whether there will be an impact on market sentiment.”
The analysis comes after the CSRC, the regulator of China’s junk bond market, announced that investors will be on their own in the inevitable event that a bond defaults, impressing upon them that the government will be hands off.
"Local governments and exchanges will not provide any form of risk relief…So don't have any delusion about government or exchange bailout. Default by bond issuers is a regular occurrence in the global market," Huo Da, deputy director of the CSRC's bond office, reportedly said on July 17 in a meeting of managers from 53 securities brokerage firms qualified to underwrite high yield bonds, reported Caixin Online.
This is a departure from China’s ongoing practice where banks roll over the debt of bond issuers facing the prospect of default – quietly and often at the urging of the local government. This has led China’s debt market to avoid defaults for 20 years.
However, public sentiment toward this practice has changed. Earlier this month, a group of lawyers and Jiangxi province community members reportedly approached regulators on the legality of bailing out Xinyu-based solar panel maker LDK Solar with taxpayer money.
The Xinyu municipality ended up paying a portion – rumoured at Rmb800 million (US$125.4 million) - of LDK Solar’s debts.
That event came three months after Shandong Helon nearly became China’s first issuer to default on a bond. But as the chemical fibre maker was on the verge of missing payment on its Rmb400 million one-year bond, local regulators intervened and pledged funding by state-backed banks.
Yet the stakes for China have increased with the launch of its high yield bond market in June. That arena was set up to help give cash-hungry small-and-medium-sized enterprises (SMEs) a necessary funding avenue, as bank lending for these borrowers has been sparse in recent years.
But these SMEs by nature are riskier prospects than investment-grade issuers, as most do not have a track record in the debt market, and many remain unrated.
Most high yield issuers in China will be rated from 'A-' to ‘BB’ according to China’s local rating system. This translates to a far lower rank on an international ratings system. For example, Standard & Poor’s (S&P) China rating scale, a ‘cnAAA’-rated bond issuer can be equivalent to anywhere between a ‘AAA’ to a ‘A’ rated bond on the agency’s international rating scale.
Given this reality, there is a real potential that a default will eventually hit the market.
The CSRC has granted 31 SMEs licenses to issue bonds onto this junk bond market via private placements. A reported 28 have already completed deals.
Moody’s Chung says that the CSRC has long planned to get the junk bond market off the ground, and at a time when the government is trying to broaden the debt market to include more than state-backed players, an early default would derail all positive momentum. For this, local governments will continue supporting their bond issuers.
“High yield issuers are more vulnerable to defaulting, and the high yield market would hardly attract investment if it sees a default at its infancy stage,” said Chung. “It’s likely that, if any of the early issuers were in trouble, it would get support. Also, regulators would likely scrutinise the early issuers to make sure they’re better quality, but the market will develop and get larger over time and this will have to be revaluated.”
Yet there is a sense that market regulators truly look to turn over a new leaf.
“It’s believable that the government is trying to step away from these defaults – it wants to draw the line somewhere and let everyone know that they can’t expect the government to back up every company in trouble,” said Larry Jiang, chief strategist of Guotai Junan International. “There’s been more anti sentiment on this topic in China, too, so the government wouldn’t want to promise that it will keep saving companies.”
While Jiang concedes that regulators may still step in to save flailing companies – and will likely do it under the radar and away from the public eye – the CSRC’s decision to vocalise its stance is “something to applaud”.
“But when it comes down to it, a lot of the local governments and banks do have stakes in their local companies, so if something were to happen, there would be support if a company is necessary to a community,” he added.
But in terms of China’s junk bond market, a default will still be a way off. Only select names, such as internet service provider Nine Start Technology and Beijing Hongysifang Radiation Technology, have been granted approval to issue in the market, and these have been relatively safe companies with good financial track records. They’ve also been mandated to sell bonds with at least a one-year long tenor, which suggests that the first default would be at least months away.
“It might take six to 12 months before we see any defaults,” said Chung. “Unless there’s a case of fraud or human error, we won’t see anything until at least the first cycle of bonds is complete.”