Worrying frenzy in China's domestic corporate bond market

New data from Dealogic on China's domestic corporate bond market, which re-opened in the middle of last year, shows Chinese corporates issued ¥175bn ($27bn) by 19 February 2016, helped by interest rates up to 3% lower than offshore markets and the removal of exchange-rate risk. MarketWatch says the concern is not just the size of China's corporate bond issuance but also the structure of this nascent market; despite the appetite for these new domestic bonds, there is practically no secondary trading, just an assumption that bonds remain valued at par and will be held to maturity. This only works as long as corporates can pay coupons and principal on maturity and there is no rush to exit in the interim period. The fear is that the market is starting to resemble China's equity market, where a rush of investors fuelled a bubble. Furthermore, a switch in sentiment towards corporate bonds could prove painful if trade freezes in the absence of secondary liquidity. 

HONG KONG (MarketWatch) — A move by Chinese authorities to boost bank lending used to be guaranteed to also boost equities. But with authorities struggling to cope with huge debt levels and capital outflows, today it’s just as likely to spook investors worried about financial stability.

The decision by the central bank on Monday to cut reserve ratio requirements by 0.5% should boost bank lending by up 700 billion yuan, yet the fear is it might just make it easier for stimulus to leak overseas.

The sanguine view is China can keep adding debt so long as a surge in bankruptcies or bad debts is avoided.

Debt accumulation shows few signs slowing down. Latest figures in January revealed aggregate lending reached a record 3.42 trillion yuan.

This adds to an already scary debt pile.

According to McKinsey, China’s corporate debts excluding financial institutions have reached 131% of gross domestic product, double the level in the U.S., while total debts reached 290% of GDP by the middle of 2015.

But perhaps it’s time to watch for a new fault line in China’s debt bubble.

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Attention is now turning to China’s recently reopened domestic corporate bond market. According to data from Dealogic, Chinese corporates had already issued 175 billion yuan worth of bonds by Feb. 19 this year.

Since the middle of last year when the regulator gave the nod to reopen China’s onshore corporate bond market after a six-year hiatus, there has been a headlong rush into bond issuance by Chinese companies. The majority of those active have been Chinese property developers who have switched issuance onshore.

The attraction was obvious: interest rates up to 3% lower than offshore markets, while borrowing onshore also removed potential exchange-rate risk.

At the same time, mainland Chinese investors and institutions have enthusiastically lapped up this new paper. The ongoing decline in China’s stock markets has spurred investors to look for a safer home for their money.

In theory, high-yield bonds should be less volatile than equities, given they are more concerned with downside protection not earnings. The caveat is default risk and patchy liquidity brings another level of risk, which is why high-yield corporate debt is typically the preserve of professional investors.

The concern with China’s corporate bond issuance spree is not just its size but also the structure of this nascent market.

Despite the appetite for these new domestic bonds, there is still practically no secondary trading. Instead, there is just an assumption that bonds remain valued at par and will be held to maturity.

This works so long as corporates can pay coupons and principal on maturity and there is no clamor for exits by bondholders in the interim period.

However, the fear is that investors’ rush into bonds is following the pattern of China’s equity market before, where a herd mentality fueled a bubble.

Further, if there is a switch in sentiment towards corporate bonds, the pain could be compounded if no one is able to trade due to a lack of secondary liquidity.

For example, in the U.S., the high-yield market has been badly hit by the double whammy of corporate stress and bond-fund redemptions.

Default risk is usually limited in the period immediately after bond issuance as firms have just received a capital injection. Much depends on the ability to refinance down the line.

As well as questions on the lack of secondary liquidity, another concern is the objectivity of China’s domestic rating agencies, which are often state owned. Recently they have assigning higher ratings to Chinese company bonds onshore than the offshore bonds rated by international agencies.

This combination of highly indebted corporates, limited liquidity and questionable pricing of risk hardly sounds likely a recipe for a sustainable market.

Another consideration is how China’s bond issuance resurgence is impacting the offshore market. So far there have been a series of commentaries on this positive development as it has helped push up the price of offshore bonds due to a scarcity premium as offshore issuance dries up.

More recently there have been reports that Chinese investors have become more interested in the offshore market, adding another liquidity tailwind.

This would make sense give the higher yields on offer and the current preference to diversify out of a weakening yuan USDCNH, +0.22% .

While premiums between Chinese onshore and offshore equities are common, a poser is why should yields on the offshore bonds be higher? One explanation is this is just another example of intervention by Chinese authorities distorting prices.

But if China’s heavily geared corporates do finally run into trouble, where would you rather be holding bonds? Higher offshore yield might be justified, as it’s a fair bet they will get paid only after domestic bond holders.