Chinese bonds: buyer beware

China’s bond markets should be basking in adulation. While the coronavirus pandemic continues, the news for issuers and buyers of Chinese debt securities in the early months of 2020 has, superficially at least, been pretty good.

On the final day of February, JPMorgan included the country’s government bonds in its benchmark emerging-market indices for the first time, opening the door to as much as $20 billion in additional foreign institutional capital.

This followed the decision to include Chinese bonds in the Bloomberg Global Aggregate Index in April 2019 – the first such move by a large index provider.

Each was a landmark event for China’s $14.3 trillion bond market, the world’s third largest after the US and Japan. And there are wider ramifications. Beijing has courted institutional investors since 2015, when a stock market crash led to an exodus of foreign capital and a sharp fall in the value of the renminbi.

After that shattering event Beijing moved, slowly at first and then with greater speed, to expand market access to foreign investors and underwriters.

In 2017 it launched Bond Connect, allowing foreign bond investors to invest via Hong Kong in Chinese bonds. And in September 2019 the interbank market regulator, Nafmii, handed Type-A licences to Deutsche Bank and BNP Paribas, allowing both to act as lead underwriters on corporate debt printed by domestic non-financial institutions.

In the main the country’s actions – designed to support the renminbi while its current account surplus shrinks and to plug holes in a leaky and unproductive economy – have worked.

Foreign investments in Chinese debt rose 28% year on year in the first quarter of 2020, according to the Bond Connect Company, a joint venture between Hong Kong Exchanges and Clearing, and CFETS, the interbank trading and forex division of China’s central bank.

That sharp uptick in ownership by foreign institutions took place even while Beijing struggled to contain the domestic spread of Covid-19.

It’s worth nothing that foreign investors remain marginal players onshore. Collectively, they own roughly 2.2% of all outstanding Chinese debt and their focus is concentrated on a select number of products, notably short-term non-convertible debentures issued by development banks.

But it’s impressive in its own way and a further sign, as if one were needed, that this could be China’s century. How else to interpret the fact the country that gave birth to the pandemic has seen its bond market transformed into a financial safe haven.

But this is China, and nothing here is ever quite that straightforward. Even as fresh sources of foreign capital flooded into mainland debt securities, curious things were happening on the ground.

Take the fact that cases of corporate defaults in the first quarter of 2020 fell rather than rose. Monthly cases of mainland issuers defaulting on debt repayments peaked in September 2019 at 25, before declining steadily.

In February, with China in full lockdown, there were just three defaults. In April, there were six.

“It’s counterintuitive,” says Logan Wright, director of China markets research at Rhodium Group, the independent research firm that assembled the data. “You can’t assume that defaults will rise while the economy is tanking, but it’s a reasonable conclusion.”

As Allen Feng, an analyst at Rhodium, wrote in a research note published May 4 and entitled ‘Cheating on the test does not mean you passed’, this slowdown is “an illusion”.

The reality, he noted, is that bond issuers are “simply becoming more creative” at dodging technical defaults.

This manifests itself in many ways. Some issuers are “persuading or threatening investors to withdraw put options,” says Feng.

Others may prefer to try to extend bond maturities or to swap old bonds for new ones. For bondholders who assume the issuer will always act in a right and proper way and with investors’ interests firmly in mind, things can quickly become a nightmare.

Take the case of strong-arming on the put option. Its origins lie in the last period of monetary easing, pursued by the central bank in 2015. Mainland issuers were keen to raise capital and cut funding costs, while investors were wary of buying securities with a longer-dated maturity.

A compromise was reached of firms printing debt with a put option available at the end of the second or third year.

But when credit conditions tightened after 2017, some of the more badly run issuers faced a dilemma. Knowing they would struggle to meet their debt obligations, they were forced to decide whether to default on the paper in public or find a way to convince investors not to exercise their put option. 

Sometimes the sweet-talking succeeded. When it didn’t and talks broke down, some issuers chose a more passive-aggressive play, threatening to default if investors forced their hand, or pledging to pay interest only to those bondholders who chose to hold on to their paper.

The opacity that pervades the Chinese financial landscape means it’s not always easy to spot when this happens.

In March 2019, a Shenzhen-listed jewellery maker called Jinzhou Cihang said all holders of a 2+1 year bond with a put option due at the end of that month had decided to exercise it, cashing in on their investment.

Then on April 9, the firm said 80% of bondholders had reversed their initial decision following “negotiations”. Even so, Jinzhou Cihang failed to repay its investors.

Another way for a company to avoid detection when it cannot meet its liabilities is to renegotiate terms with bondholders outside the usual channels.

Issuers typically receive a message from China Securities Depositary and Clearing (CSDC), the body responsible for all securities clearing services for the Shanghai and Shenzhen stock exchanges, one working day before a bond matures. After that message arrives, it is up to the issuer to ensure it has enough capital in its account.

But there is no hard-and-fast rule here. If an issuer knows it is financially constrained, it might engage directly with bondholders in the hope of reaching an accord.

Investors may accept the terms grudgingly, but it’s a win for China’s clearing houses, which are absolved of the need to declare a public default, and for the issuer, which gets to save face, in public at least.

Rhodium Group identified four cases of issuers defaulting in private, having bypassed the clearing system, in 2019 alone. But as there are no official records of this kind of default, experts say the actual number is likely to be much higher.

A final way for issuers to dodge publicly defaulting on their bonds relates to coronavirus.

It is common practice in China for firms to take on new loans to repay older ones. It’s a key reason why non-performing loans are widely viewed as being under-reported by state-run banks, which regularly roll over loans to zombie companies for fear of incurring the wrath of their political masters.

Still, in normal conditions, borrowers have to reach some kind of technical settlement with regulators involving the old debt before they can secure fresh funds. Covid-19 has changed all that.

These days, policymakers, desperate to keep the economy and corporates afloat, are in many cases simply and automatically letting firms roll over maturing bank loans.

That strategy, notes Rhodium Group’s Feng, “is now being applied to publicly traded bonds as well.

“In recent months, extensions are being agreed before bond maturity dates, avoiding outright defaults entirely,” he adds.

Other issuers are simply replacing old debt with new bonds with a later maturity date and typically bearing a higher coupon.

The consultancy points to a host of mainland firms that have used swaps and extensions to dodge default since the start of 2020, including Beijing Sound Environment Engineering and Wafangdian Coastal Projects Development, a local government financing vehicle (LGFV) from the northeastern city of Dalian.

In some cases, issuers have resorted to desperate measures to avoid defaulting publicly on their debt.

On March 19, the Shanghai Clearing House said it did not receive a coupon payment from Shandong Ruyi for a Rmb1 billion ($141 million) 7.5% medium-term note (MTN) sold a year earlier.

The textiles firm then went on a rollercoaster ride. It fired its main Chinese ratings agency after Dagong downgraded the issuer and four of its renminbi-denominated bonds. S&P then withdrew its ratings at the company’s request.

Ruyi then admitted that it held a bondholders meeting on March 17, two days before it missed its payment, at which – it claims – all nine holders of the paper, including at least one offshore investor, agreed not to register the late payment as an official default. 

All eyes will now be on a five-year Rmb500 million bond that becomes puttable in September 2020 and a Rmb1.9 billion MTN that matures a month later, according to data from Shanghai-based Wind Information.

Some attempts by issuers to wriggle out of repaying their debts by massaging the rules border on the comical.

Take HNA, an aviation-to-hospitality conglomerate from the southern island of Hainan. On April 15 the troubled firm was due to make an Rmb390.4 million repayment on a seven-year Rmb1.15 billion bond.

But at 8pm the previous day HNA executives held an impromptu get-together to announce plans to extend the principal and interest payments on the bond.

Many investors didn’t know about the meeting – unsurprising given that the troubled firm only posted the announcement on the website Chinabond.com after it had finished.

Those that managed to attend participated in a spirited discussion described by GlobalCapital as raucous and tense. The motion was passed, but only because three investors, collective holders of 98.26% of the paper, approved it. The other 29 investors voted against it.

But if HNA’s slippery attempt to avoid the inevitable was laughable, was Gemdale’s worse?

On April 22, the property firm said in a filing to the Shanghai Stock Exchange that it would cut the coupon on an outstanding Rmb1 billion bond to 1.5%, from 5.29%.

Wait a minute, said investors, pointing out that issuers are entitled to raise the coupon but cannot lower it.

The response from one brokerage was truly Kafkaesque. It declared that it had indeed increased the coupon – by adding a negative figure to the original sum. If the resulting number was lower not higher than the original one, surely someone or something else – perhaps mathematics itself – was to blame.

Does this matter? Yes. China’s economy is not particularly productive.

Even before Covid-19 threatened to push the world into recession, mainland policymakers were engaged in a constant struggle to generate enough freshly minted capital to maintain the desired high level of domestic growth.

Beijing cannot generate all the money it needs. The economic model it is so proud of is built in large part on a vast 30-year influx of foreign capital.

If the People’s Republic is to continue to expand at a reasonable pace, a sizeable share of the capital it needs “will have to come from external sources, and that is why China is determined to continue to attract more foreign institutional capital,” says Avinash Thakur, head of debt origination for Asia Pacific at Barclays.

This growth model has a secondary purpose. Beijing also recognizes and respects the immense power of Wall Street. If it is to be a true superpower, bursting with vibrant startups and strong multinationals, it must build world-class capital markets. And to achieve that it needs outside help.

Foreign investors and financial institutions are keen to be, and to be seen to be, willing long-term partners. Crédit Agricole tips the onshore bond market to quadruple in size by 2025, to between $47 trillion and $55 trillion, putting it on a par with the US.

It is surely only a matter of time before China’s debt market becomes the world’s largest and most liquid and heavily traded.

Even the current pandemic is unlikely to throw the market fully off its stride.

“The mainland’s bond markets have been pretty resilient throughout recent months, and the allure of investing in the best onshore bonds remains,” notes Thomas Fang, head of China global markets at UBS. “After Covid-19 settles down, you’re only going to see more global funds looking to diversify by investing in the best Chinese bonds.”

If there’s one factor that could disrupt the market’s smooth and rapid growth, it is China itself. More specifically, it is the country’s periodic ability to shoot itself in the foot.

Trust in China’s financial markets is not limitless. Foreign investors would be wise to remember that when Mao Zedong’s communists seized power in 1949, they refused to meet the obligations of prior regimes.

That left funds and governments from the Americas to Asia holding wads of worthless – but also collectible and rather elegant – paper bonds.

Nor should investors assume that Beijing will instinctively bail out every troubled state firm. That certainly wasn’t the case in 1998, when Guangdong International Trust and Investment defaulted on an $8.75 million payment on a $200 million bond.

When the state-backed investment firm later collapsed with Rmb38.77 billion in debts, it left international banks and funds holding yet more reams of worthless paper.

Can foreign investors trust Chinese bonds and the issuers that print them any more in 2020 than they could in 1998 or 1949?

It was long assumed that Beijing would not permit corporate defaults for fear of fomenting social unrest at home and unease among foreign investors.

But in 2014 a privately owned solar panel maker called Shanghai Chaori failed to meet interest payments on its bonds. The die was cast, and in 2019 two state-run firms forced investors to take losses on US-dollar bonds, including Tewoo Group, a commodities trader owned by the municipal government of Tianjin.

In that sense, recent events matter a great deal. No mainland firm, notes Rhodium Group’s Wright, wants to be known as “just the latest one to default”.

Likewise, China’s desire to prop up its companies at a time of deep economic stress is wholly understandable. Countries are resorting to all sorts of budgetary gymnastics in an attempt to stave off a wave of Covid-related defaults and bankruptcies.

But the chequered history of China’s financial markets means policymakers need to try twice as hard to turn foreign investors from doubters into believers.

It is notable that in spite of the rise in foreign ownership of mainland bonds in the first quarter, 2020 has been a difficult year for mainland securities in general. In March, at the height of China’s fight against Covid-19, $29.9 billion in foreign portfolio capital (mostly equities) fled the country, before rebounding a little in April.

In broad terms, China needs the world’s leading funds, government agencies, endowments and sovereign wealth vehicles to put their money to work in onshore debt securities – including bonds issued by LGFVs – safe in the knowledge that even if an issuer defaults, it will do so in a logical and orderly manner.

In this context, the behaviour of HNA and Gemdale, not to mention the maybe dozens of other firms that have threatened investors to withdraw put options, swap old bonds for new ones or just quietly default on the down-low, does no one any good at all.