In January we pointed out "the last bubble standing," as China's crashing equity market had spurred massive inflows – directed by a "well-meaning" central-planning committee's propaganda – sparking a massive bubble in Chinese corporate bond markets (in an effort to enable desperately weak balance-sheet firms to roll/refi their debt and keep the zombies alive). That has now ended as China's junk bond risk has soared to 5-month highs with its worst selloff since 2014. As HFT warns, "we should avoid junk bonds."
China’s high-yield bonds are in the midst of their worst two-month selloff since the end of 2014 and investors say they have yet to fully price in the risk of defaults as the economy slows. The gap reached a four-month high of 379 basis points, from as low as 352 on Jan. 19, as at least seven companies reneged on bond obligations this year, up from one in the same period of 2015.
As Bloomberg details,
“Most high-yield bonds haven’t fully priced in default risks,” said Zhao Hengyi, Shanghai-based deputy director of the bond fund department at HFT Investment Management Co., which oversees 46.9 billion yuan ($7.2 billion) of assets. “We should avoid junk bonds.”
Premier Li Keqiang has pledged to pull support from zombie firms that have wasted financial resources and dragged on economic growth, which is slowed to 6.7 percent in the first quarter. Chinese companies must repay a total of 31.3 billion yuan of bonds rated AA- or lower this year, the most on record, according to Bloomberg data based on rankings from the nation’s four-biggest rating firms. Corporate notes rated AA- or lower are considered as junk bonds in China.
China’s corporate debt burden is heavy, but if you have a lot of savings and lending, the leverage compared with countries without high saving rates is not very high, People’s Bank of China Governor Zhou Xiaochuan told a briefing in Washington on Thursday. The PBOC has lowered benchmark interest rates six times since 2014, driving a record rally in the bond market and underpinning a jump in debt to 247 percent of gross domestic product.
At least 37 Chinese firms postponed or scrapped 35.2 billion yuan of planned note sales through April 13, compared with nine companies pulling 12.4 billion yuan a year ago, data compiled by Bloomberg show. About half of the cancellations took place this week after state-owned China Railway Materials Co. halted its bond trading Monday.
“The recent default events have hurt investors,” said Xu Gao, chief economist at Everbright Securities Co. in Beijing. “So it’s natural for bond yield spreads to go up.”
As BofA warns however, there are signs that the risk-free rate in China may have bottomed and that the credit spread is widening.
This may check any enthusiasm in the market, in our view. We consider the latest rally to be tactical and we don’t recommend that investors chase it. We maintain our year-end target for HSCEI of 9,000 and, for SHCOMP, 2,600.
Chart 1 shows the 5-year Chinese Government Bond (CGB) yield vs. CSI300. At the risk of oversimplifying, we separate the market’s behaviors into two phases: before mid-2013, Phase I; post mid-2013, Phase II. We judge that market confidence in fundamentals, i.e., the earnings outlook, was generally strong in Phase I; but weak in Phase II.
In Phase I, the bond yield generally correlated positively with CSI300’s performance. When the yield rose, investors, in general, believed that the economy was strong enough to endure some tightening. As a result, they were willing to continue to bid for stocks for a while.
On the other hand, in Phase II, investors were much less confident: when the yield rose, the market almost immediately came under pressure; when the yield fell, the rebound was mostly muted (except the artificial rally from mid-2014 to mid-2015, underpinned by perceived implicit government guarantees) and often with a significant lag. Actually, since mid-2015, despite the sharp drop in rates, A-shares have continued to be under pressure.
Now, interest rates appear to be experiencing upward pressure. If they indeed move up noticeably, we would expect market sentiment to weaken fairly quickly.
The key question for us is, if interest rates indeed rise noticeably, will the market resort to the Phase I thinking, i.e., believing that the growth is strong enough to handle the rise? While we cannot rule out the possibility, we believe that this is unlikely, given the tentative stabilization of macro conditions and the continued surge in debt.
We leave it to Xia Le to conclude,
"The equity rout merely reflects worries about China’s economy, while a bond market crash would mean the worries have become a reality as corporate debts go unpaid," said Xia Le, the chief economist for Asia at Banco Bilbao. "A Chinese credit collapse would also likely spark a more significant selloff in emerging-market assets."
"Global investors are looking for signs of a collapse in China, which itself could increase the chances of a crash… This game can’t go on forever."
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