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FINANCIAL CHRONICLE™ » DAILY CHRONICLE™ » China Junk Bonds Pose Most Risk Since ’04 on Credit-Quality Dips

China Junk Bonds Pose Most Risk Since ’04 on Credit-Quality Dips

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Investors in Chinese junk bonds are taking the biggest gamble in at least a decade.
Leverage for speculative-grade Chinese companies is at its highest since at least 2004, whether measured by earnings relative to interest expense or total debt to a measure of cash-flow, according to data compiled by Bloomberg using a Bank of America Merrill Lynch index. Borrowers have also piled on the most debt relative to their assets since 2007.

The deterioration in credit quality coincides with the slowest annual growth since 1990 for Asia’s biggest economy, and helps explain why Fitch Ratings Ltd. predicts defaults will climb. That’s bad timing for bond investors who swallowed a record $209.2 billion of Chinese-company notes denominated in either dollars, euros or yen last year, Bloomberg data show.

“The credit cycle in China has peaked,” said Hong Kong-based Arthur Lau, the head of fixed income for Asia ex-Japan at PineBridge Investments Asia Ltd., which manages $35.3 billion of debt globally. “Corporate earnings are negative in general and investors are bracing for a deterioration in metrics.”

The typical high-yield company in China earned an average 2.7 times the interest they paid in 2014 and has about 35.5 times more debt than their yearly operating income, according to data compiled by Bloomberg using Bank of America Merrill Lynch index data. Average debt taken out by the 65 companies in the index climbed to 34.3 percent of assets.

Skipping Payments

In the past month, developer Kaisa Group Holdings Ltd. and coking-coal importer Winsway Enterprises Holdings Ltd. have both missed bond coupon payments, and water-treatment company Sound Global Ltd. flagged potential audit issues. Hotpot restaurant-turned-Internet firm Cloud Live Technology Group Co. also became the second onshore-debt defaulter ever in China after failing to repay noteholders.
China’s debt has ballooned amid soaring bad loans and shrinking industrial profits. Aggregate social financing, a measure of credit that covers traditional and off-balance sheet lending, increased to double China’s gross domestic product at the end of December. While that’s below the peaks reached earlier last year, it’s close to the highest since Bloomberg started tracking the data in 2003.

“When credit grows that fast, it’s normally a strong sign misallocations of capital have taken place,” Sander Bus, the head of high-yield credits, and Victor Verberk, the head of investment-grade credits, at Dutch money manager Robeco Groep NV, wrote in an April 10 e-mail.

Rating Downgrades

“We wouldn’t be surprised if China, and some other emerging countries that face similar increases in debt, turns out to be the place of the third episode of the global financial crisis after the U.S. and Europe,” they wrote. Robeco had about 246 billion euros ($260 billion) in assets at the end of 2014.

Moody’s Investors Service lowered the scores of Chinese junk-rated companies 11 times in the first three months of 2015 and only upgraded once, Bloomberg data show. The ratio is the worst since at least 2006.

“There are two reasons for downgrades, one is that companies take too much debt and the other is that the operational environment is deteriorating,” said Joep Huntjens, the head of Asian debt at Netherlands-based NN Group NV, which had about $197 billion under management as of Dec. 31. “What’s happening in China is the latter, a lot of companies are suffering from excess capacity.”

Stimulus Prospect

Moody’s said on March 11 that 5.1 percent of the high-yield companies it scores in China had defaulted in 2014. The number of defaults rose to five in 2014 from two in 2013, pushing the trailing 12-month high-yield default rate for Asian non-financial corporates to 3.9 percent, up from 2.2 percent the previous year.

The ratings company downgraded Yingde Gases Group Co. by one step to Ba3 on Jan. 27, citing challenges in a weak steel industry. Yingde’s ratio of debt to assets increased to 53.6 percent at year end from 49.7 percent in 2013.
While corporate earnings “won’t be that pretty over the next six months,” Nikko Asset Management Ltd. is getting more positive on high-yield bonds because China may bolster its monetary and fiscal stimulus, according to Singapore-based high-yield bond manager Wai Hoong Leong.

People’s Bank of China Governor Zhou Xiaochuan said in a speech last month there’s still room for monetary policy action while Premier Li Keqiang, who set a 2015 growth target of about 7 percent versus 7.4 percent last year, pledged to take steps if expansion slows toward the lower limit of that range.

“We can’t be too negative and we have come to a neutral stance from an underweight in January,” said Leong, whose firm managed $160 billion of assets as of Sept. 30. “We’re prepared to add risk, and have done so in the past month.”
Yield Spreads

The extra yield, or spread, investors demand to own Chinese junk bonds narrowed to 8.42 percentage points as of April 13 from 11.38 percentage points on Jan. 19, that was the highest since June 2012. The spread is up 0.32 points during the past 12 months while yield premiums on investment-grade debt in China have narrowed 0.21 points to 1.72 percentage points, Bank of America Merrill Lynch data show.

Banks have become more bearish on Chinese-company securities as the nation’s growth has slowed. Morgan Stanley has recommended investors hold a smaller percentage of high-yield debt than their benchmark indexes since December 2013.
Goldman Sachs Group Inc. cut its outlook on China’s property industry to negative in September, citing leverage worries. Deutsche Bank AG also lowered its property industry recommendation to negative from neutral in January on contagion risks from Kaisa, which had total interest-bearing debt to onshore and offshore lenders of 65 billion yuan ($10.5 billion) as of Dec. 31, according to a Feb. 16 filing.

Kaisa Bonds

Kaisa’s 8.875 percent bonds due in 2018 and sold at par, or 100 cents on the dollar, in March 2013, traded as low as 29.6 cents in January. They jumped 6.3 cents to 69.6 cents Monday after founder Kwok Ying Shing returned to helm the company three months after he resigned amid a corruption probe and were last at 70.7 cents.

“We’re still cautious on Chinese high yield because of the frequency of companies getting into problems given the pressure on the balance sheets,” Viktor Hjort, the head of Asian credit research in Hong Kong at Morgan Stanley, said by phone April 9. “We’re bullish on investment-grade corporates, a bigger part of the Chinese bond market where fundamentals are improving for the first time in four years, and the supply of bonds is declining.”

The latest 2014 filings showed Winsway and underground mall builder Renhe Commercial Holdings Co. didn’t earn enough in their normal course of business to pay interest on their borrowings. Texhong Textile Group Ltd., developer Oceanwide Holdings Co. and Yingde Gases had the highest amount of debt compared with their assets.

Winsway is the midst of restructuring its debt to improve its financial situation, Beijing-based spokeswoman Laura Shi said by e-mail Monday. Officials at Yingde, Texhong and Renhe didn’t reply to e-mails and phone calls seeking comment.
“You’re seeing a deviation from the mean among Chinese speculative-grade companies,” said Kalai Pillay, a senior director at Fitch in Singapore. “Some are getting better, some are getting worse, but the overall trend is for default rates to rise.”

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