A Balancing Act – Challenges in China’s Bond Market

The Chinese government has just bailed out a distressed debt manager. Should this be taken as an “all clear” signal for the country’s bondholders?

Asia Pacific Head of Fixed Income

On 18 August 2021, the Chinese government made a move that caused many bondholders to breathe a sigh of relief. It announced that it would bail out a state-owned debt manager – via a recapitalisation estimated at US$7.7 billion. The distressed manager, with US$242 billion in liabilities, had just posted a record US$15.9 billion loss for 2020 after multiple delays in releasing its 2020 results. At the time of writing, its shares remain suspended 1.

Even better, the manager in question also announced that it had no plans to restructure its debt, which suggests that bondholders won’t need to take a haircut. For many, this was a sign of the “implicit guarantees” baked into the bond prices of many state-owned enterprises (SOEs) – particularly the more reliable and strategically important ones. 

But is this truly the case?

SOE Defaults Remain on the Horizon

The truth is that this debt manager is an outlier among SOEs because of the sheer size of its liabilities. In June, the company, and its peers, had a combined US$454 billion worth of liabilities, including US$28 billion of outstanding dollar bonds 2 . Allowing it to default would have created a substantial chance of contagion.

Ultimately, the company proved “too big to fail”. Importantly, the statistics on the broader SOE landscape show that this incident shouldn’t be taken as the norm.

In 2020, Chinese state firms defaulted on a record US$11.1 billion worth of debt3 . In the first half of 2021, a total of 25 SOEs defaulted on an aggregate US$5.7 billion in bonds – another record4 . And credit ratings agency Fitch is expecting the volume of SOE defaults to rise in the second half of the year as they stare down a large maturity wall5

Even though the debt manager was eventually bailed out, the timing also shows that the Chinese government is trying to send a clear message. 

Beijing’s High-Wire Act

The Chinese government had a balancing act to manage. On the one hand, there was the risk of financial contagion. On the other was the possibility of perpetuating the moral hazard that has allowed SOEs to borrow an estimated US$2.2 trillion6 . This includes “hidden debt” raised off the balance sheet of local governments, but which carry an implicit guarantee of state support. The government has even designated this hidden debt a national security risk.

For the recent bailout, Beijing decided to step in only toward the last moment. Markets had been concerned about the situation since April when the March 31st deadline for filing the debt manager’s 2020 results was missed7 . In the intervening months, the company’s bondholders had already sold at heavy losses – making this government rescue “too little too late” for many8 . The debt manager’s domestic bonds fell by almost 30% through April9 , and these declines had quickly spread to its dollar bonds10 .

Further, the recapitalisation will be led by a state-owned conglomerate, while the debt manager had previously been directly owned by the Ministry of Finance. This moves the company one step further away from government control – weakening the case for future support11 .

China’s Corporate Bond Market

In another development, the recent crackdown on China’s private education and tech companies has created a degree of uncertainty that has caused the country’s corporate bonds to lag their benchmark indices12 . The spread between US and Chinese high-yield paper has also hit fresh highs.

There is also the question of a leading Chinese property developer with US$300 billion in liabilities13 . The company has suffered repeated downgrades on escalating risks of debt non-payment, having also failed to repay some commercial paper on time in June14 .

The firm is currently trying to raise cash and trim debts by selling off assets, but there is a strong possibility that its bondholders will have to take significant haircuts.

The Hunt for Yield

Developed bond markets appear to have shrugged off the inflationary spikes, meaning the search for yield continues. So, it is understandable that higher-yielding assets like Chinese corporate bonds are so appealing.

Further, the Chinese government allowing more SOEs to default may ultimately be positive for the market. In the meantime, a middle ground may prove more appropriate. By focusing on Chinese sovereign and quasi-sovereign bonds with explicit government guarantees, investors can protect their downside while still capturing significant yield pickup and diversification benefits.