• This research is part of a white paper that provides a comprehensive look at the rising number of defaults in China - why the are occurring, why they are a good thing in the long run, and what investors should do about them. 
• It can be downloaded here.

Growing pains

The growth of China’s domestic bond market has been nothing short of breath-taking - more than quadrupling in size from 20 trillion renminbi in 2010 to 90 trillion renminbi in 2019. And as quickly as it is growing, it is transforming towards a more market-oriented system. One of the most significant steps in this transition has been the government’s consent for companies to default on their debt payments. The first corporate bond default came in 2014, caused by slower growth and tighter liquidity conditions throughout the economy. Since then, the steady trickle of corporate defaults has grown. 

First time issuer defaults in mainland China. Source: WIND, Fidelity International, August 2019.

The long-run benefits of a proportionate number of corporate defaults far outweigh the downsides. Defaults help reduce moral hazard by introducing consequences for overly aggressive risk taking at companies and banks. This encourages credit to be priced more accurately, a critical requirement for capital to be allocated in the most efficient way. Simply put, poorly managed businesses should not be able to borrow at the same rate as well-managed competitors. Differentiated credit spreads also encourage investment by fairly compensating those who bear more risk.

However, there are several obstacles to realising these potential benefits: falling risk sentiment, the concentration of onshore credit ratings in highly-rated categories and undeveloped bankruptcy law. 

Bondholders must therefore prepare for the worst in default cases. Corporate bond defaults are a recent phenomenon in China, meaning that bankruptcy laws are relatively untested. This makes it difficult for investors to work out what they can expect to recover in a default and therefore accurately assign value to different parts of the capital structure. To shed some light on this, we analysed bondholders’ recovery rates for the onshore default cases up to June 2019, and the primary finding was that recovery rates are declining.

Source: Fidelity International, August 2019.

In 2015, the weighted average recovery rate bondholders could expect was 40 per cent. In 2018, that figure fell to just 1 per cent. While some of the most recent defaults may yet see bondholders recompensed to some degree, our analysis shows that 80 per cent of defaults have been resolved in under six months, meaning that the majority of cases currently unresolved are likely to conclude with bondholders receiving nothing.

Default is no longer a dirty word for regulators

The fall in recovery rates for bondholders is due to regulators’ growing acceptance of defaults. Initially, the resolution of defaults was treated as a priority by local governments worried about public perception. Officials saw high recovery rates as a way to minimise potential market jitters. State-owned banks were often last in line behind retail investors and bondholders, despite the seniority of the debt they held. 

However, now that defaults are more common, authorities have greater confidence that they will not precipitate a market panic. Officials now handle defaults with less urgency. Retail investors are still generally repaid first and often in full. But institutional bondholders are finding a positive resolution more difficult, as cases grind through opaque bankruptcy proceedings.

Our research also revealed that:

• While the average default rate over the entire period is 8 per cent, the distribution is largely binary: of the 124 issuers we analysed, bondholders received nothing in 75 per cent of cases and were fully reimbursed in 15 per cent.
• The weighted average recovery rate for state-owned enterprise bonds (SOE) in default is 16 per cent, but only 6 per cent for privately-owned enterprise (POE) bonds. This is mainly due to a dramatic weakening in collection rates since 2018. In contrast, there was no difference between the recovery rates of the two ownership types before 2018.

What this means for investors

Despite falling recovery rates, defaults still represent a small part of the onshore bond market. By allowing defaults, authorities have taken another step towards greater market maturity.

However investors should be cautious of buying distressed bonds and be fully prepared to receive nothing in the event of a default. Thorough company analysis is paramount because the majority of defaults are preceded by deteriorating financial performance, which can be identified in advance.

Investors should be equally wary of buying distressed bonds issued by private or state-owned companies. While the recovery rates for SOE bonds are higher than those for POE bonds, the figure is still low. In addition, the price of bonds issued by POEs usually falls in advance of a default announcement, but the same is not true of SOE bonds as in many cases markets still expect the state to intervene. So in the relatively rare event that an SOE does default, bonds prices can fall dramatically.

No pain, no gain

We firmly believe that a manageable level of corporate defaults is a positive development for China’s bond market in the long run; a natural step for a maturing market. If China can embrace the idea of ‘no pain, no gain’ when it comes to defaults, then the subsequent improvements in risk pricing should help capital flow to better-run companies and expand the opportunities available to investors, especially as the onshore bond market becomes ever more accessible.

Nonetheless, China’s corporate bond market will continue to operate with its own idiosyncrasies even as it matures, making it difficult to accurately anticipate which firms are allowed to default, which investors get recompensed and how debt is restructured. As social harmony is an important consideration for the government, company analysis will need to include more than just financial ratios. Debt seniority will not always be observed in resolution. Analysts must assume that firms making a significant contribution to local employment or occupying a strategically important spot in a supply chain are more likely to receive government support.

The uneven application of rules will make it harder to navigate the market with certainty and investors may have to build a higher discount rate into their models. It is hardly surprising that the rapid growth and transition of China’s bond market has resulted in a few growing pains. But these are manageable and the rewards are there for those with the ability to find them.

• This research is part of a white paper that provides a comprehensive look at the rising number of defaults in China - why the are occurring, why they are a good thing in the long run, and what investors should do about them. 
• It can be downloaded here.