• One of the largest problems with the Chinese bond market is the variable treatment of creditors.
• Recent high profile and messy bond defaults in China have unnerved financial markets.
• Chinese authorities are gradually and painfully breaking up implicit government guarantees and improving market discipline, but at the same time trying to avoid triggering large spillover impacts on the economy.

The Chinese bond market needs a more predictable bond default mechanism and resolution process, and its regulators know this. When a bond issuer is unable to repay its obligations, a transparent reorganization or liquidation of assets is critical in order to ensure that market participants will be willing to use this market again over time. A set of “guiding opinions” jointly issued by the People’s Bank of China (PBOC) and the China Securities Regulatory Commission (CSRC) on August 18, 2021 is evidence that the regulators understand this and should be seen as a meaningful step forward.¹²³

These guiding opinions discuss the opening up, reform and development of the bond market in China, now the second largest in the world; and they were likely prompted by a recent series of high-profile defaults and scandals as well as those looming on the horizon. The guidelines aim to unify the rules for China’s different bond market venues, strengthen oversight and law enforcement, and clarify which securities laws and regulations are applicable in each venue, with an emphasis on their consistent application to all borrowers. The release of these guidelines is evidence that Chinese regulators understand the need for better functioning bond markets and is a step in the right direction. However, when one looks at the way some defaults continue to unfold in China and the many idiosyncrasies of its bond market, it is clear that much work lays ahead.

Cross-default Provisions and Other Covenants

One of the largest problems with the Chinese bond market is the variable treatment of creditors. Equal treatment of creditors is typically ensured through cross-default provisions in indentures; these provisions provide a contemporaneous claim to assets in the event of default on any obligation in the capital structure. For instance, if a company defaults on a bank loan, the cross-default provision is triggered and that company now also defaults on bonds which contain this provision, allowing all creditors to get in an orderly line for a restructuring or a liquidation. While the number of newly issued corporate bonds in China with this feature increases each year, my analysis of publicly available data indicates that only 23% of bonds issued on the exchange traded market in 2020 contained cross-default provisions.⁴

Despite their increasing presence in indentures, cross-default provisions in the Chinse bond market sometimes function differently than in international bond markets.⁵ The triggers for a cross default can be less robust in China, and this allows for bilateral creditor negotiations and out-of-court resolutions rather than transparent and comprehensive restructurings with all creditors represented in the process. Other features typical in international bond indentures – such as negative pledge, change of control, limitations on indebtedness, and restricted payments – tend to be weak or non-existent in Chinese bond indentures.⁶

Figure 1 illustrates some key covenant differences between the offshore U.S. dollar (USD)-denominated bonds (ticker EVERRE) and the onshore Renminbi (RMB)-denominated bonds (ticker EVERCN) issued by Evergrande Group, a heavily indebted property developer in China. The covenants listed here are designed to protect the interests of creditors and provide them with equal rights to a borrower’s assets in the event of default; their absence in the onshore RMB-denominated indenture is a material negative from a bond holder’s perspective. This is just one example of how the Chinese domestic bond market has much further to go if it wants to catch up with the covenant standards that prevail in more mature markets.

New Defaulted Bond Recovery Guidelines Versus Ongoing Chinese Bond Defaults

Despite the introduction of defaulted corporate bond recovery guidelines in December 2019, Chinese bond issuers continue to ease or postpone debt repayments by issuing rollover debt, seeking repayment deadline extensions, or cancelling features such as early redemptions.⁷ Some issuers have avoided default by undertaking private negotiations with individual creditors, often persuading bondholders not to exercise put options, deferring interest payments on perpetual securities, forcing debt exchanges, or even repaying bondholders outside the proper clearing channels some days or weeks late.⁸ The bond market prefers certainty and transparency: it likes standardized resolutions, in which creditors within each class are treated equally, and creditors across classes are treated fairly relative to their respective contractual rights. If regulators continue to tolerate the opaque and crafty tactics that have been prevalent in the past, investors will remain hesitant, and the market’s development will be stunted.

China’s regulators published additional guidelines in July of 2020 to clarify the role of bond trustees and the structure of creditor meetings, with the aim of making the default process more market-oriented and transparent. These guidelines include allowing defaulted bonds to continue to trade on qualified exchanges, encouraging more widespread use of credit derivatives and enhanced information disclosures to creditors.⁸ Such recommendations are wise and necessary for a market that is young, large and growing quickly, but the implementation of these recommendations remains a work in progress.

The increased transparency on the debt resolution process sought by these series of guidelines should give international investors more confidence, but subsequent high-profile defaults – such as that of Yongcheng Coal and Huachen Automotive – have rightly unnerved financial markets.⁹ Yongcheng Coal is a state-backed coal miner in Henan province which defaulted while in possession of AAA local bond ratings and ample cash on the balance sheet. Yongcheng later disclosed to creditors that much of its cash balance was “restricted,” prompting speculation that the default perhaps served a strategic purpose.¹⁰¹¹¹² While Yongcheng’s bond underwriters, auditor and rating agency have been accused of breaking capital market rules, the company continues to operate after pushing back a deadline for principal repayment in closed-door meetings with investors.¹³ Huachen Automotive, the parent company of BMW’s partner in China, transferred assets to a subsidiary just prior to its bond default, likely meaning bondholders will be unable to access these assets in a restructuring or liquidation.¹⁰¹⁴ These are just two examples of messy defaults in the Chinese bond market which have yet to be fully resolved.

Shortly after these two incidents, the Chinese authorities warned all borrowers that the government will take a zero-tolerance stance on fraudulent bond issuance, disclosure of false information, the malicious transfer of assets, and misappropriation of issuance funds.¹⁵ I remain a sceptic that these statements apply to all bond issuers based on events unfolding in China’s indebted residential property sector. Evergrande is facing a major restructuring; as part of this process the real estate developer has been selling equity stakes to raise cash and its founder has stepped down as chairman of its mainland subsidiary. This move may constitute an attempt to distance the listed Hong Kong parent, where much of the debt resides, from the mainland operating company, where most of the assets lie.¹⁶ Distancing onshore assets from the offshore holding company and its liabilities is contrary to statements and guidelines from regulators and is a development that should concern investors.

Trends that will Strengthen Foreign Investor Appetite for Chinese Bonds

The best way to increase foreign investor appetite for and promote the advancement of the Chinese bond market is the reliable invocation of the default mechanism when issuers get into financial trouble. A default mechanism that is applied in a transparent and consistent manner and not upended by an unfair and messy state intervention. The restructurings of Evergrande and Huarong Asset Management, the biggest and most troubled of China’s asset management companies, will be herculean tasks. Investors are watching closely to see how these high-profile restructurings will work out. While Evergrande and Huarong’s paths are quite different, there is a level of opacity at both and this is not healthy for the development of China’s bond market.

Chipping away at implicit guarantees would be another important step in the maturation of this market. Again, I will use the examples of Evergrande and Huarong. Evergrande is a privately-held entity, but does the size of its liabilities (and breadth of political connections) mean that it is too big to fail? Huarong is majority owned by the Ministry of Finance – is that an implicit or explicit guarantee, or no guarantee at all? These are two big and important questions overhanging China’s bond market.

While Chinese authorities have been working to reduce moral hazard related to investments by increasing tolerance for defaults and bankruptcies, they simultaneously remain steadfast in wanting to avoid major dislocations or damage to the economy, as evidenced by the way these two large financially-troubled entities are being treated with kid gloves.¹⁷ On September 14, China’s regulators informed the country’s major banks that Evergrande will not be able to make a bank loan interest payment due on September 20, prompting the question: is Evergrande in default or will it extend payments and roll over obligations with government assistance?¹⁸

The presence of foreign rating agencies in China may also help this bond market mature. One only need look at bond ratings of Evergrande to see that the local rating agencies are not contributing much to the healthy maturation of this market. Figure 2 shows the ratings evolution of Evergrande’s USD-denominated offshore bonds and RMB-denominated onshore bonds. As of September 15, China’s Chengxin rating agency still had a local issuer rating of single A for Evergrande despite a preponderance of evidence that a restructuring is inevitable.

Despite continued questions about the usefulness of domestic rating agencies, change could be on the way. In early August, the PBOC announced that non-financial companies can issue bonds without needing to get a rating from an external rating agency, a move designed to “promote market-oriented reform of the credit rating industry.”¹⁹ This is in line with international bond markets where ratings are not mandatory, thus requiring investors to either have their own credit assessment capabilities or to rely on credible rating agencies for that task.

A concentration of bondholders, low liquidity, and the low frequency with which credit is repriced are other issues impacting the Chinese bond market. Whereas previously bonds were often held to maturity on banks’ balance sheets, the development of a secondary bond market has enabled a transition to a broader investor base. Holder concentration has shifted from the commercial banks toward domestic asset managers, domestic insurance firms and foreign investors. This continued diversification in bond holders should help enhance bond liquidity and increase the frequency with which credit is repriced.

Conclusion

Financial stability continues to be a top policy priority in China. More tolerance for bond market defaults with transparent resolutions rather than unpredictable and opaque government interventions would be a meaningful development. The regulators are gradually and painfully breaking up implicit government guarantees and improving market discipline, but at the same time trying to avoid triggering large spillover impacts on the economy. The government’s ability to control both asset and liability sides in the credit market has allowed the Chinese authorities to avoid a major crisis. As such, and in light of China’s large and growing bond markets, full transparency or consistent application of the default mechanism could take some time.

We are watching China’s capital markets evolve before our eyes. More transparent defaults, more standardized covenants in bond indentures and better ratings could help to bring more foreign participation to China’s domestic bond market. What happens with a few large looming restructurings will be critical to this effort.

The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.

As of June 30, 2021, the Seafarer Funds did not own shares in the entities referenced in this commentary.

1. In this case, the guiding opinion covers a range of issues: restricting bond sales by highly leveraged companies, prohibiting companies from buying their own bonds, promoting convergence of the interbank bond market and the exchange traded bond market in terms of standards to strengthen supervision and law enforcement, and improving oversight of credit ratings agencies. The strengthening of supervision and law enforcement should make the default process in China more predictable and have a meaningful positive impact on investor sentiment.
2. Source: Zhang Yukun and Peng Qinpin, “China’s Regulators Set Out Plan to Overhaul Scandal-Hit Corporate Bond Market,” Caixin Global, 24 August 2021.
3. “Guiding Opinions on Promoting High-Quality Development of Corporate Credit Bond Market Reform and Opening,” People’s Bank of China and China Securities Regulatory Commission, 18 August 2021.
4. Seafarer, Bloomberg. Data as of 31 December 2020.
5. “Credit FAQ: China Paves Way for Better Default Resolution Systems,” S&P Global Ratings, 28 July 2020.
6. Peter Guy, “Asian Covenant Quality Drops Driven by ‘Chinese Property Bonds’,” CityWire Asia, 3 February 2021.
7. Molly Dai, “China’s Corporate Bond Defaults Unveil Hidden Blind Spots,” Bloomberg, 1 July 2020.
8. “China’s Corporate Bond-Market Stress May Persist in 2021,” Fitch Ratings, 16 November 2020.
9. Samuel Shen and Andrew Galbraith, “Worried China Bondholders Call for Protection as Restructuring Wave Looms,” Reuters, 29 April 2020.
10. Danielle Levy, “What’s Going On with China’s Corporate Debt Drama,” Citywire, 4 February 2021.
11. Xie Yu and Chong Koh Ping, “Large Chinese Broker Faces Probe After State-owned Coal Miner’s Default,” The Wall Street Journal, 19 November 2020.
12. Sun Yu and Tom Mitchell, “Fall of China’s ‘Most Profitable’ Coal Miner Is a Cautionary Tale,” Financial Times, 8 December 2020.
13. Kenji Kawase, “China’s Yongcheng and Unigroup Survive Despite Series of Defaults,” Nikkei Asia, 4 February 2021.
14. Sun Yu, “China State-owned Group Caught in Default Storm Owes Banks Billions,” Financial Times, 30 November 2020.
15. “China Vice Premier Liu He Vows Zero Tolerance for Misconduct After Recent Bond Defaults,” Reuters, 21 November 2020.
16. Shuli Ren, “Evergrande Isn’t HNA. It Might be Worse,” The Washington Post, 18 August 2021.
17. Angus Lam, David Li, Lei Yi, and Yating Xu, “China’s Bond Defaults,” IHS Markit, 28 December 2020.
18. “China Tells Banks Evergrande Won’t Be Able to Pay Interest due on September 20th,” Reuters, 14 September 2021.
19. “China Eases Restrictions on Non-Financial Corporate Debt Instruments,” The State Council of The People’s Republic of China, 15 August 2021.