Understanding the relationship between bond issuers and China’s central government is one of the most important issues an investor must master before venturing into the $12 trillion local-currency bond market — the third largest in the world after the US and Japan.
Many borrowers can claim some sort of link with the central government in Beijing, however tenuous that may be. Only a few years ago bond issuers would exploit this ambiguity. Encouraging belief in an implied government guarantee could secure funding, or cheaper funding, despite blatant credit risks. This, in turn, encouraged excessive risk taking, distorted asset pricing and made fundamental credit analysis redundant.
This changed in 2014. Policymakers recognised the moral hazard they had created and so they stopped routinely bailing out troubled issuers and rolling over bank loans from government-controlled lenders. Bond default, once an exotic concept in China, became a real risk. Since then, government-linked issuers have had to demonstrate ‘strategic’ value to qualify for a valuable government guarantee.
Bond defaults are on track to beat last year’s tally, according to data compiled by Wind, a Chinese financial data provider, and our own calculations. Twenty seven bonds with a face value of some 27.1 billion yuan (US$3. 9 billion) have defaulted year-to-date (as of August 10, 2018) compared to 48 bonds worth some 37.6 billion yuan in 2017, albeit down from the 60 bonds worth 39.3 billion yuan that defaulted in 2016.
Strategic, not strategic
So what is considered ‘strategic’? Organisations set up by China’s State Council to execute national policy still provide the safest of safety nets. For example, China Investment Corporation, the sovereign wealth fund, is considered as important as the Ministry of Finance.
Also ‘strategic’ are the so-called ‘policy’ banks, such as China Development Bank, which play a major role in financing government-directed investments, as are the big commercial lenders, like Industrial and Commercial Bank of China, which are systemically important. Many companies under the auspices of the State-owned Assets Supervision and Administration Commission of the State Council (SASAC) are also covered. There are around 100 SASAC firms at the central government level, including state-sanctioned monopolies that operate the national grid and develop oilfields among other activities.
Local government debt — municipal bonds, local government financing vehicles (a legacy funding platform) and debt linked to ‘market competitive’ state-owned enterprises — is harder for bond investors to assess. There are close to 3,000 SASAC companies operating at the local government level and their ‘strategic’ value can often be difficult to gauge. One trick, however, is to look at whether a business provides a public service or is solely profit-focused.
For example, some government-linked companies are engaged in commercial activities such as property development and consumer manufacturing. Recent announcements have made clear they will need to make their own way in the world.
The authorities have tackled moral hazard in other ways. The new municipal bond market draws a clear line between local and central government risk; local governments have been forced to reclassify their debt into categories based on contingent risks, and to cut ties with entities that don’t provide an obvious public service; local officials have been warned they would be punished if they flout these rules, even years after they’ve moved to new jobs.
Price is right
Since last year, we have started to see fundamental risk better reflected in bond pricing. We’ve seen this in the pricing of domestically-rated AAA, AA+ and AA paper, and we have even seen it for bonds that are assigned the same rating but differ in quality. But these fundamentals include political risks. The yields of bonds from issuers that are deemed strategically important, or are set to benefit from new policies, also trade at narrower yield spreads over government benchmarks.
These are encouraging improvements, but proper bottom-up credit analysis and credit-risk differentiation based on individual names are still a way off. As more foreign investors take their first steps into this market they will become aware of its many idiosyncrasies. These can pose risks for the unwary, but they also present considerable opportunities for those who are patient and can do their own credit analysis.
— Edmund Goh is an Investment Manager, Fixed Income — Asia at Aberdeen Standard Investments.