What credit pros are watching as defaults rise in China

These are perilous times for holders of Chinese corporate bonds.

Record domestic defaults and the biggest dollar-debt delinquency by a state-owned company in two decades have jolted investors this year, underscoring the need for increased vigilance as the economy slows and Chinese policy makers scale back support for a slew of cash-strapped businesses.

As bondholders adjust to a new – and arguably more healthy – environment where companies are allowed to default, these are some of the indicators they’re watching to avoid getting burned.

Nearly half of all China’s stressed-dollar debt – bonds yielding at least 15% – come due over the next 12 months. Market volatility is likely to increase around periods with big maturities as struggling companies attempt to pay off or refinance their debt.

Weekly growth in the volume of debt moving into stressed territory rose to a record this year. The value of China dollar bonds with yields above 15% surged by $4.1 billion on Dec. 10 from a week earlier, to $25.6 billion.

Property companies dominate issuance in China’s high-yield offshore bond market. They borrowed a record $80.7 billion of debt in 2019, though that figure may drop by as much as 20% next year as new regulations aiming to restrict the industry’s leverage take effect.

The spread between China’s AAA rated onshore corporate bonds and those with AA grades – considered as junk in China – continued to tighten towards the end of year. One-year premiums shrank to 20 basis points, the lowest level in more than a decade, suggesting investors are becoming comfortable with risker bets as the country’s capital markets become more efficient.

Similarly, the spread for speculative-grade dollar notes dipped, as the Federal Reserves monetary easing stoked demand. As BB rated bonds rallied toward year-end, securities one rating group lower, at B, offered even better returns.

This could change if investors become spooked that onshore bond failures spill into the offshore market. “When I see offshore dollar high-yield spreads, especially single B to BB spreads, grow further apart, it can be a warning sign for how fearful people are of potential defaults,” said Raymond Wong, a fixed-income portfolio manager at China Galaxy International Financial Holdings.

Foreign demand for China’s domestic corporate bonds has remained strong this year even as defaults climbed – a measure of the market’s resilience. While government and state-owned policy bank debt is still favored, credit as a percentage of total onshore bonds bought by foreign investors rose to record highs in 2019. Bloomberg