Making sense of China bond market defaults

With better economic news being offset by headlines about defaults and missed payments, investors would be forgiven for thinking that the credit backdrop in China is somewhat gloomy. Yet, when viewed over a longer timeframe, we believe these developments will ultimately be a force for good. The Chinese authorities see these events as an opportunity to tackle lingering issues and develop a sustainable corporate bond market positioned for long-term growth.

Image taken from the ground point of view, looking up at a forest of tall, green trees

Key takeaways

  • China is allowing more debt defaults, but in a controlled manner. State-owned enterprise (SOE) defaults should mostly come from those with low strategical importance or weak fundamentals. 
  • China aims to promote market-oriented debt resolutions for SOEs. 
  • A new three-year reform program should play a vital role in developing the onshore bond market.
  • In our view, China's offshore U.S. dollar bond default risk is manageable.
  • Recent funding curbs on China’s property developers aim to manage housing market risk.
  • Proprietary research can fill the information gap, providing investors with additional details on each issuer.

Despite the recent increase in credit events, we believe the case for investing in Chinese corporate bonds remains strong, with the search-for-yield theme still very much in play. We acknowledge the issue of Chinese corporate debt defaults, but in our view, with careful credit selection, the country’s credit market can remain a good opportunity for investors. China’s economic and demonstrated market resilience—with a spread premium over developed bond markets—places it in a unique global position.

China U.S. dollar credit can offer a spread pickup versus U.S. corporate bonds

Chart comparing the blended spread of J.P. Morgan Asia Credit Index with the blended spread of ICE Bank of America U.S. Corporate Index from August 2010 to June 30, 2021. The chart shows that the spread of J.P. Morgan Asia Credit Index is consistently higher than the ICE Bank of America U.S. Corporate Index throughout the period.
Source: Bloomberg, Manulife Investment Management, June 30, 2021.

The big picture: recent credit events and the continuing credit cleanup

During the first half of 2021, we saw an increasing number of onshore and offshore credit events, with the number of year-to-date onshore bond defaults already exceeding 50% of the full-year total for 2020.¹ Instead of kicking the can down the road, we believe the Chinese government is allowing more debt defaults in a controlled manner as a continuation of the credit cleanup that has been taking place over the past few years. We think this approach is positive for the financial health of the corporate sector, especially property and SOEs. Policymakers now have a higher tolerance for defaults amid the sustained recovery in China’s economy that has materialized since the second quarter of 2020. Also, we see an increasing willingness to let creditors bear associated losses, which represents a shift from the prior belief that the government would bail out bondholders of failed financial institutions. More market-driven and orderly defaults should lead to credit risk pricing that is more reflective of credit fundamentals.

While these defaults may lead to market jitters and a widening of credit spreads, our base case is that SOE defaults will likely be seen among those with low strategical importance or weak fundamentals and may not cause systemic risk.² In our view, the recent trend of large and high-profile SOE defaults highlights the importance of fundamental credit analysis and credit selection, especially in the China onshore bond market where there’ limited credit differentiation and government support is taken for granted. 

SOE reforms amid rising onshore defaults

While market dynamics are resulting in a healthier and more sustainable credit environment, government reform also plays an increasingly indispensable role in developing the onshore bond market. In June 2020, President Xi Jinping approved a new three-year reform program,³ a development that has kick-started a new round of mergers and asset restructuring among central and local level SOEs in areas such as steel and the infrastructure space. In summary, the program is designed to help SOEs become more competitive and market-driven while solidifying the central government’s influence on SOEs and, in turn, enhancing SOEs’ influence in those strategic industries aiming to achieve national goals (e.g., carbon neutrality by 2060).⁴

Issuers’ total notional amount of onshore bonds outstanding at the time of default, as a percentage of total corporate bonds outstanding at the start of the year

Chart comparing total notional amount of onshore bonds outstanding issued by state-owned enterprises at the time of default (expressed as a percentage share of total corporate bonds outstanding at the start of the year) against the same metric for privately-owned enterprise from January 2014 to June 25, 2021. The chart shows that the percentage share of state-owned enterprises that remained outstanding at the time of default (when expressed as a percentage share of total corporate bonds outstanding at the start of the year) is significantly lower than that of privately-owned enterprises.

Source: Goldman Sachs, June 25, 2021.

As the COVID-19 situation in China has stabilized and the economy is broadly recovering, onshore defaults could pick up moderately. Based on the latest guidance, the central government aims to promote more market-oriented debt resolutions for SOEs, with a greater tolerance for insolvent local government financing vehicles (LGFVs) to default. While we expect the process to be gradual, we believe that the so-called zombie SOEs and LGFVs could be default candidates. Zombie attributes include very weak fundamental profiles, limited strategic functions, and exposure to highly polluting industries such as coal mining. Having said that, with an overall default rate of less than 1%,⁵ SOE default risk should remain manageable given the efforts by local government to smooth the process without causing a systemic impact on local funding channels. We believe there are more opportunities in SOE issuers—particularly those with sound credit profiles, consistent financial policy, and the ability to ride through cycles with manageable fallen angel risk. Also, we believe issuers with clear strategic importance will warrant government support to offset any fundamental weakness arising from their policy function.

Amid the post-COVID-19 recovery, we expect an improving operating environment, and the broad price recovery in commodities should alleviate some of the pressure on privately owned enterprises (POEs). Since the weaker POEs have already defaulted, we believe that the default rate should moderate from the record high witnessed in 2019.

Offshore credits: policy tightening may lead to consolidation for property developers 

Overall, we think the default risk in China’s offshore U.S. dollar bond market is manageable, as China’s offshore high-yield (HY) market is dominated by local property developers.⁶ As the Chinese government continues with its more proactive approach to managing systematic risk in the sector, we don’t expect sharp credit deterioration or widespread defaults. Given the significance of the property sector in terms of its contribution to the economy and its role as a store of wealth, we believe it’s in China’s interest to promote healthy and sustainable development within the sector instead of adopting an abrupt intervention that could lead to sharp price corrections and a drastic surge in defaults. In fact, we’re already seeing some uptick in single B-rated⁷ developer defaults. 

China G3 HY bond market default rate (weighted by outstanding amount)

Chart showing the risk/return profile for a hypothetical portfolio of China bonds and global government bonds, using data from January 2013 to May 2021. The chart shows how different combinations would have fared in terms of risk and return. A 100% allocation to global government bonds would have offered the lowest annual returns (about 1.4%) and the most risk (about 5.1%). A 50/50 split between global government bonds and China bonds would’ve increased annual returns (to around 2.6%) and decreased risk (about 3.9%).

Source: Goldman Sachs, as of June 17, 2021.

The recent funding curbs on China’s property developers aim to manage risk in the housing market, which is showing signs of overheating. This approach, essentially a form of policy tightening, will inevitably lead to challenges for weaker developers with limited access to funding and financial flexibility. That said, we expect the overall default risk in the sector to be manageable. Under the People’s Bank of China’s three red lines rule,⁸ developers with excessive leverage will come under pressure to slow their pace of expansion and focus on improving the quality of their growth, which we think may improve their credit profiles over time. Furthermore, we believe that larger developers with financial flexibility and access to funding should play a greater role in the industry’s consolidation over the coming years. We believe this would lead to further polarization within the sector and accelerate consolidation over the medium to long term.

We believe that developers with decent scale and financial strength to buffer the ride through various market cycles should stand out. These companies tend to have ample land reserves either nationally or in major economic clusters where they hold leading market positions. In addition, developers with access to diversified funding channels in both the onshore and offshore markets should be in an advantageous position. In our view, this is critical to a developer’s liquidity position as well as its long-term success. 

The importance of both onshore and offshore research presence

China’s credit market is the world’s second largest and one that’s still growing.9 As China’s onshore and offshore bond markets continue to develop, the information gap in these markets becomes more noticeable. At Manulife Investment Management, we take pride in our bottom-up fundamental research capabilities, with both onshore and offshore research presence, including dedicated credit analysts in Shanghai and Beijing. When assessing the creditworthiness of a local or central SOE, we believe it’s essential to understand the entity’s role in the eyes of either local or national government, and their access to onshore and offshore funding. Often, developments in the onshore market could be verified through our team’s offshore presence, and vice versa, to understand the relevant nuances. Having both an onshore and offshore presence with access to on-the-ground intelligence, therefore, fills the information gap by providing us with an additional layer of detail on the quality of each issuer. Ultimately, this market knowledge helps us identify attractive opportunities for our investors.

 

1 Goldman Sachs, June 21, 2021. So far, the default rate of SOEs in China remains below 1% (of total China onshore corporate bonds outstanding), which is a level that’s low compared with other bond markets around the world. Chinese authorities have shown in the past that they’re willing to take bold measures to support and restore confidence in the market to prevent any contagion risk.  3 “SOE reforms to drive economic development,” China Daily, June 5, 2020. Premier Li Keqiang delivered the government work report on May 22, 2020, in which it was announced that China will launch a three-year action plan for SOE reform, improve the system of state capital regulation, and intensify mixed ownership reform of SOEs. 4 “China pledges to be “carbon neutral” by 2060,” Financial Times, September 23, 2020. 5 Goldman Sachs, June 25, 2021.  6 These make up about 46% of the J.P. Morgan Asia Credit Index (JACI) China high-yield segment. 7 Single B-rated debt instruments are widely considered to be speculative in nature and carry high credit risk. 8 The People’s Bank of China and the Ministry of Housing announced in 2020 that they had drafted new financing rules for real estate companies. Developers wanting to refinance are being assessed against three thresholds: a 70% ceiling on liabilities to assets (excluding advance proceeds from projects sold on contract), a 100% cap on net debt to equity, and a cash to short-term borrowing ratio of at least one. 9 Bank of International Settlements, June 23, 2021.

A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange-trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future, could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other pre-existing political, social and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment.

Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments.  These risks are magnified for investments made in emerging markets. Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a portfolio’s investments.

The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person. You should consider the suitability of any type of investment for your circumstances and, if necessary, seek professional advice.

This material is intended for the exclusive use of recipients in jurisdictions who are allowed to receive the material under their applicable law. The opinions expressed are those of the author(s) and are subject to change without notice. Our investment teams may hold different views and make different investment decisions. These opinions may not necessarily reflect the views of Manulife Investment Management or its affiliates. The information and/or analysis contained in this material has been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use of the information and/or analysis contained. The information in this material may contain projections or other forward-looking statements regarding future events, targets, management discipline, or other expectations, and is only current as of the date indicated. The information in this document, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Investment Management disclaims any responsibility to update such information.

Neither Manulife Investment Management or its affiliates, nor any of their directors, officers or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained here.  All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife, Manulife Investment Management, nor any of their affiliates or representatives is providing tax, investment or legal advice.  This material was prepared solely for informational purposes, does not constitute a recommendation, professional advice, an offer or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security or adopt any investment strategy, and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Diversification or asset allocation does not guarantee a profit or protect against the risk of loss in any market. Unless otherwise specified, all data is sourced from Manulife Investment Management. Past performance does not guarantee future results.

Manulife Investment Management

Manulife Investment Management is the global wealth and asset management segment of Manulife Financial Corporation. We draw on more than a century of financial stewardship to partner with clients across our institutional, retail, and retirement businesses globally. Our specialist approach to money management includes the highly differentiated strategies of our fixed-income, specialized equity, multi-asset solutions, and private markets teams—along with access to specialized, unaffiliated asset managers from around the world through our multimanager model.

This material has not been reviewed by, is not registered with any securities or other regulatory authority, and may, where appropriate, be distributed by the following Manulife entities in their respective jurisdictions. Additional information about Manulife Investment Management may be found at manulifeim.com/institutional

Australia: Hancock Natural Resource Group Australasia Pty Limited., Manulife Investment Management (Hong Kong) Limited. Brazil: Hancock Asset Management Brasil Ltda. Canada: Manulife Investment Management Limited, Manulife Investment Management Distributors Inc., Manulife Investment Management (North America) Limited, Manulife Investment Management Private Markets (Canada) Corp. China: Manulife Overseas Investment Fund Management (Shanghai) Limited Company. European Economic Area Manulife Investment Management (Ireland) Ltd. which is authorised and regulated by the Central Bank of Ireland Hong Kong: Manulife Investment Management (Hong Kong) Limited. Indonesia: PT Manulife Aset Manajemen Indonesia. Japan: Manulife Investment Management (Japan) Limited. Malaysia: Manulife Investment Management (M) Berhad  200801033087 (834424-U) Philippines: Manulife Investment Management and Trust Corporation. Singapore: Manulife Investment Management (Singapore) Pte. Ltd. (Company Registration No. 200709952G) South Korea: Manulife Investment Management (Hong Kong) Limited. Switzerland: Manulife IM (Switzerland) LLC. Taiwan: Manulife Investment Management (Taiwan) Co. Ltd. United Kingdom: Manulife Investment Management (Europe) Ltdwhich is authorised and regulated by the Financial Conduct Authority United States: John Hancock Investment Management LLC, Manulife Investment Management (US) LLC, Manulife Investment Management Private Markets (US) LLC and Hancock Natural Resource Group, Inc. Vietnam: Manulife Investment Fund Management (Vietnam) Company Limited.

Manulife, Manulife Investment Management, Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.

539829

Fiona Cheung

Fiona Cheung, 

Head of Global Emerging Markets Fixed Income Research

Manulife Investment Management

Read bio