The China Banking Regulatory Commission office is seen in Beijing. The CBRC is proposing to restrict individual investors from buying exchange-traded bonds rated below AAA rating.

Bloomberg/Shanghai

 

Bond brokerages have a New Year’s resolution proposal for China’s policy makers: allow more defaults among so-called zombie companies. The extra yield on three-year AA rated debt over top-ranked notes surged 47 basis points last month to December 25, the most for any month since October 2011, even after China’s first onshore bond payment in March failed to trigger a shakeup in the market. Borrowers graded at or below that rating need to repay a record 632.3bn yuan ($101.6bn) of notes in 2015, up 71% from 2014, China International Capital Corp data show.

President Xi Jinping must balance the need to support an economy set for its slowest growth in more than two decades with reining in the world’s biggest corporate liabilities that Standard & Poor’s estimates stood at $14.2tn in 2013. Haitong Securities Co and Fitch Ratings say that will require greater use of bankruptcy laws.

“Zombie companies will face higher borrowing costs, which will force more failures,” said Li Ning, a bond analyst in Shanghai at Haitong, the nation’s second-biggest brokerage. “That’s a good thing for the economy because allowing more defaults is a necessary step in building a sound financial asset pricing system.”

Haitong Securities’ Li said the number of bond defaults may increase next year and investors should shun lower-rated corporate debt because their yield premium over top-rated notes may rise. Zombie companies are using up too many lending resources, Liu Shiyu, who was deputy governor at the People’s Bank of China and is now chairman of Agricultural Bank of China, said earlier this year.

In the only one onshore default China has had, investors didn’t lose a cent. Shanghai Chaori Solar Energy Science & Technology Co, which failed to make a full coupon payment in March, repaid all the principal and interest for its 1bn yuan of bonds.

“It’s necessary to let those zombie companies default,” said Wang Ying, an analyst at Fitch Ratings in Shanghai. “If there is no real default, risks will never be priced in a correct way. Without a correct risk pricing mechanism, zombie companies can still survive by getting loans from banks.”

Wang said if there are more defaults like Chaori in which investors at the end of the day get their money back, that will encourage reckless market activity known as moral hazard.

“More investors will buy those troubled companies’ bonds because they think the premium is high and it’s risk free,” she said.

Shi Lei, the head of fixed-income research at Ping An Securities Co, said another troubled company, Sinovel Wind Group Co, whose bonds Lianhe Credit Rating Co downgraded to BBB from A in November, may make full repayment should noteholders demand it buy back 2.6bn yuan of securities it sold in 2011.

Sinovel said in a statement to the Shanghai Stock Exchange that it had paid 2.56bn yuan to buy back most of the 2016 notes. Its shares, which resumed trading, closed up 5.1% last week at 4.37 yuan in Shanghai. Sinovel’s payment means the government is avoiding a second non-payment in China’s public bond market, Shi said. That market includes corporate debt regulated by the China Securities Regulatory Commission and medium-term notes supervised by the central bank. The CSRC started a private bond market for smaller companies in 2012, where bonds are issued via private placement and little information is available to outsiders.

Premier Li Keqiang said on March 13 the government will ensure there is no systematic risk, six days after Chaori Solar missed part of an interest payment.“Regulators are very unwilling to see defaults in the public bond market because they equal defaults to sources of systematic risk,” Shi said. In the private bond market, where non-payments wouldn’t have such a big impact on financial stability, Shi said their number may still increase next year. That’s because Chinese companies’ credit profiles will worsen even after the central bank cut interest rates for the first time last month, he said.

Chinese banks’ nonperforming loans rose by 72.5bn yuan from June 30 to 766.9bn yuan at the end of September, the highest level since 2008, the China Banking Regulatory Commission said. Soured credit accounted for 1.16% of total advances, up from 1.08% three months earlier.

“Banks are reluctant to lend because they’re worried about possible defaults,” Beijing-based Shi said. “With tighter credit and a slower economy, companies’ credit quality will be worse than this year.” Banks’ bad-loan coverage ratio, a measure of reserves for soured credit, fell to 247.2% as of September 30 from 262.9% in June, the CBRC data showed. The CBRC is proposing to restrict individual investors from buying exchange-traded bonds rated below AAA.

The rules to bar such investors from putting their money in high-yield debentures show regulators are preparing for more defaults in the public bond market, according to Qiu Xinhong, a money manager at First State Cinda Fund Management Co who recommends investment-grade notes.

He also said the gap between top and lower-rated company bond yields may widen unless monetary policy is loosened over the coming 12 months.

“The full repayment of Chaori debt doesn’t mean the government won’t allow defaults,” Shenzhen-based Qiu said. “Individual investors don’t have a sound knowledge of the bond market.

 

 

 

 

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