What China’s Recent Bond Defaults Mean For Investors
A once high-flying oil and gas producer is the latest among a string of Chinese companies to default on their debt obligations this year. As of late May, the number of defaulted issuers in China stood at eight, a number that is approaching the 10 recorded in all of 2017. The eight issuers have defaulted on the interest and principal payments of 16 bonds worth a combined RMB14.4 billion. So should investors be worried about what appears to be rising credit risk in China?
While the defaults have no doubt caused jitters in the stock and bond markets in recent weeks, they are isolated cases that do not reflect the overall health of Chinese corporates.
Contrary to what may be popular belief, credit defaults account for only a tiny share of the non-financial corporate bond market in China. The RMB108 billion of papers that Chinese companies have defaulted on since 2014 – when China saw its first corporate bond default – account for only less than 0.5% of the RMB20 trillion Chinese non-financial corporate bond market.
Defaulting issuers also exhibited certain tell-tale signs. Of the eight issuers that have defaulted this year, six were private-sector companies that were for the large part aggressive in their business operations and investments and carried large lumps of debt – especially short-term debt – on their balance sheets. Defaulting issuers also typically had weak profitability, poor operations, tight cash flows and limited cash on their balance sheets. The demise of these companies was likely an intentional result of deleveraging and de-risking measures that Chinese authorities have been implementing to weed out poor quality companies.
In contrast, the big-picture fundamentals story for Chinese corporates reads very differently. Earnings for publicly listed companies jumped 23.9% in 2017 and are expected to rise another 15% in 2018, while cash flows have markedly improved since 2016. The stronger earnings combined with lower debt levels means that corporate debt is now better covered. Both the net liability-to-EBITDA and interest coverage ratios of A-share non-financial firms have noticeably improved in recent years. The average cash-to-short-term debt level of listed Chinese companies also remains high at north of 0.8 times despite the tightening credit conditions.
The key takeaway from the recent corporate bond defaults should not be cause for concern about the overall health of Chinese corporates. Instead, it should serve as a reminder of the need for meticulous on-the-ground research to unearth quality companies in a market that offers investors attractive investment opportunities but also its share of potential land mines. History shows that it’s difficult to identify companies that are prone to default risk purely based on their financials. But this is a problem can be solved through on-the-ground research that encompasses frequent company visits and close dialogue with a company’s customers, suppliers and creditors.
We are upbeat on offshore China high yield bonds. Valuations are starting to look attractive again following the recent sell off. The credit spread on China high yield papers has widened to 300 bps in early June from as narrow as 50bps in March. While liquidity conditions in China may be tightening, companies with solid corporate fundamentals should still have decent access to funding and be able to comfortably service debt. The potential thinning of new issuances in the second half of the year and investor appetite for US dollar-denominated assets on the back of a stronger greenback should also provide an additional tailwind for China high yield bonds.
Importantly, fundamentals for Chinese property developers – which account for 40% of the J.P. Morgan Asia Credit (High Yield) Index – continue to look solid. Most publicly listed developers have a good amount of cash on their balance sheets thanks to strong contract sales over the past two years. Contract sales remain strong in 2018, with China’s top 100 developers having recorded 35% year-on-year growth in contract sales for the first five months of the year. Moreover, net gearing for the Chinese property sector has fallen from 70% in the first half of 2017 to 65% at the end of last year.
In the equities arena, China stocks continue to offer investors a good hunting ground. The valuation of the MSCI China Index appears attractive at 13 times 2018 earnings, which is well below the 17 times commanded by the S&P500 Index. Structural tailwinds such as consumption upgrade and industry consolidation are poised to benefit quality companies in sectors including real estate, automotive and consumer goods. Within the China equities space, Mainland-listed A-shares also offer global investors unique benefits such as diversification and room for generating alpha through disciplined bottom-up stock picking in a relatively inefficient market.
Disclaimer: The views expressed are the views of Value Partners Hong Kong Limited only and are subject to change based on market and other conditions. The information provided does not constitute investment advice and it should not be relied on as such. All materials have been obtained from sources believed to be reliable, but its accuracy is not guaranteed. This material contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.