Bond Defaults and Stresses on China's Debt Markets

Bond defaults in China’s corporate credit markets, once unheard of, are emerging with ever higher frequency. With a flurry of defaults over the past three months, the total value of defaulted corporate bonds now totals RMB 56 billion. Additionally, once considered immune from default risk, State-Owned-Enterprises now account for nearly half of all defaulted debt.

Although analysts at local investment bank Guotai Junan characterized the most defaults as idiosyncratic, there are several signs that systematic risk lurks under the surface.

First, credit spreads have blown out. In particular, funding costs for the steel sector have soared. Although credit spreads eased back down over the past couple of weeks, the recent spike is worrying for a highly leveraged corporate sector. As the pile of debt grows, even a small hike in funding costs can severely attenuate demand for further investment. Ask Japan.

Second, bond repurchase agreement transaction volumes have begun to sag. China’s bull market for bonds over the past year and a half has been spurred in part by traders taking speculative positions funded by repo transactions. The recent decline in repo transactions is tightly correlated with higher credit spreads.

Third, and most worrying, is the net negative financing for China’s corporate sector. Firms faced with higher funding costs cancelled a slew of bond issues at the end of 2016. Additionally, last December the net bond issuance of the corporate sector was negative for the first time since 2007, per a bond-level dataset aggregated for all corporate-issued debt. Firms that had been rolling over old debt with new, a topic I’ve written about before, will now find it harder to do so.

There are two main implications here: One, as the bond market deflates we should keep our eyes open for the next destination of speculative capital sloshing through China’s financial markets. Two, if net corporate bond issuance stays negative, we could be seeing the beginning of a deleveraging.