China Inc.’s debt bills could be worse than thought in 2018

This was supposed to be the year when Chinese companies caught a break, with the amount of local bonds coming due dropping to the least since 2014. But it’s no longer looking so clear cut.

The wrinkle? So-called put options, which give noteholders the right to demand repayment even though the securities don’t mature until later years. Rising interest rates are making it more likely that investors will do just that – using the funds to buy recently issued bonds with higher coupons. There’s a record 1.25 trillion yuan (USD195.2 billion) of notes that could be put in 2018, more than three times last year, according to data compiled by Tianfeng Securities Co.

Higher-than-expected debt bills could translate into more defaults. President Xi Jinping has been stepping up a campaign to cut leverage in the financial system, and surging refinancing costs have already left more companies unable to roll over borrowings. Investors in Chinese firms also must tread carefully, as puttable bond details sometimes aren’t disclosed in domestic audited financial reports.

“It could aggravate the liquidity crunch of weak issuers and increase their default risks,” said Ivan Chung, head of Greater China credit research at Moody’s Investors Service in Hong Kong.

Chinese authorities have doubled down on steps to reduce risks posed by the world’s biggest corporate borrowings, after Xi consolidated power at a key party congress last year. Their efforts are meeting with some success – the nation is squeezing more economic growth out of new credit as borrowers cut wasteful investments. And the amount of corporate bonds maturing this year has fallen to a four- year low of 4.1 trillion yuan, according to data compiled by Bloomberg.

But various forms of borrowings that don’t immediately meet the eye threaten to slow progress. Companies have increasingly turned to perpetual bonds that can be listed as equity without adding to obligations on balance sheets, even though in practice they are essentially debt. Asset-backed securities also require extra attention when gauging a company’s borrowings.

China has the world’s biggest amount of outstanding company puttable debt. That’s in part because many investors have demanded such options, given that low trading volume in the nation’s fledgling bond market can make it otherwise hard to offload securities.

Such securities could exacerbate some debt ratios that have already been deteriorating. Excluding puttable bonds, China-listed companies had outstanding short-term debt 1.3 times in excess of cash, according to Bloomberg-compiled data based on third-quarter earnings reports. That’s up from 1.2 times based on 2016 annual earnings reports.

Moody’s generally factors in puttable bonds by adding the full amount to debt maturities at the put date for a given time period when analyzing credit risks. Of course, investors may not wind up exercising the option, but calculating potential debt bills that way makes it clear if the borrower has enough cash or other financing channels to cover short-term borrowings.

The risk that more of the notes will be sold back to borrowers is spreading. Investors exercised put options on a record 31 percent of such Chinese securities in 2017, according to Tianfeng Securities.

“As part of investment due diligence, investors should factor in the potential impact from puttable bonds being exercised,” said Wayne Lai, an analyst at Fitch Ratings. Bloomberg