It's Structural: How Puts And Perpetuals Are Adding To Default Risks In China

July 18, 2018

China's markets increasingly resemble an obstacle course. Borrowers who have managed to COUNTRY SPECIALIST slip through the noose of tightening liquidity and outrun rising default rates will soon have to climb Chang Li a towering wall. S&P Global Ratings expects defaults will continue to rise, because more Beijing companies will fail to traverse this toughening terrain. + 86 10 6569 2705 chang.li Features unique to China's domestic debt markets add to refinancing and default risk. For @spglobal.com example, many credit securities come with puts that allow investors to demand their money back SECONDARY CONTACT at predetermined intervals. A surge of puts are exercisable from the second half of 2018, and Christopher Lee this comes on top of an upswing in debt maturities. Moreover, "perpetual" bonds are anything but: Hong Kong most investors expect issuers to call these hybrid capital instruments. Failure to do so may signal (852) 2533-3562 weakened liquidity of borrowers and add further stress to market confidence. christopher.k.lee @spglobal.com Key Takeaways RESEARCH ASSISTANT Richard Wu - Tightening liquidity conditions in China have led to the biggest jump in defaults since Hong Kong 2016.

- More challenges are ahead with a "debt maturity wall" arising from July 2018 onwards.

- Debt structures, such as puttable bonds, add to vulnerabilities.

- We see potential for negative surprises in the hybrid market.

- SOE default risk is also rising, though from a low base.

So far this year, private-sector firms are responsible for rising defaults. In our view, more state-owned enterprises (SOEs) could have trouble meeting their financial obligations, including local government financing vehicles (LGFVs) in the months ahead.

This Is A Policy-Driven Default Story

In our view, tightening liquidity conditions explain China's rising defaults in the first half of 2018. The Chinese leadership's crackdown on alternative, off-balance-sheet financing has sharply narrowed funding options for companies that rely on these channels. Defaults in 2018 reached Chinese renminbi (RMB) 22.8 billion (US$3.41 billion) as of July 7. This is nearly equal to the spike seen in 2016, when plummeting commodity prices pushed some companies into the red.

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Chart 1

In 2016, SOEs (particularly those in over-capacity industries) were responsible for roughly half of all defaults. In 2018, private enterprises dominate the default scene, a sign that China's campaign to reduce financial risks is, so far, having an outsized impact on the private sector. In our view, higher rates of liquidity stress reflect policy changes rather than economic fundamentals.

Chart 2

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Table 1

Private Companies And Industrial Firms Dominate This Year's Default List

Defaulted Bonds As Of July 7, 2018

Company Amount Issuer type Bond type Default date Sector (bil. RMB)

Sichuan Coal Industry SOE PPN 9-Jan-18 Coal 0.50 Group

Dandong Port Group POE PPN 15-Jan-18 Infrastructure 0.50

Bright Oceans Corp. POE 27-Jan-18 Capital goods 0.21

Dandong Port Group POE Corporate bond 29-Jan-18 Infrastructure 2.00

Bright Oceans Corp. POE Corporatebond 28-Feb-18 Capital goods 0.76

Dandong Port Group POE Medium-term note 12-Mar-18 Infrastructure 1.00

Dandong Port Group POE Medium-term note 13-Mar-18 Infrastructure 0.90

Shenwu Environmental POE Private placement 14-Mar-18 Capital goods 0.45 Technology

Bright Oceans Corp. POE Corporate Bond 17-Apr-18 Capital goods 1.21

Fuguiniao Co. Ltd. POE Corporate Bond 23-Apr-18 Consumer 0.80

Shenwu Technology Group POE 28-Apr-18 Environmental and 1.75 facilities services

China Security & Fire Co. POE Private placement 7-May-18 Tech hardware 0.09 Ltd.

Kaidi Ecological and POE Medium-term note 7-May-18 Tech hardware 0.66 Environmental Technology

Fuguiniao Co. Ltd. POE Private placement 9-May-18 Consumer 1.30

CEFC China Energy POE "Super and short-term" 21-May-18 Oil and gas 2.00 commerical paper

Sunshine Kaidi New Energy POE Corporate Bond 1-Jun-18 Renewable electricity 1.80 Group

Zhongrong Shuangchuang POE Corporate Bond 13-Jun-18 Aluminum 0.60 Beijing Technology Group

CEFC China Energy POE "Super and short-term" 21-Jun-18 Oil and gas 2.50 commerical paper

CEFC China Energy POE 25-Jun-18 Oil and gas 2.00

Bright Oceans Corp. POE Corporate Bond 3-Jul-18 Capital goods 0.33

Wintime Energy POE Commercial paper 5-Jul-18 Coal 1.50

SOE--State-owned enterprise. POE--Private enterprise. RMB--Chinese renminbi. PPN--Private placement note. Note: PPNs are regulated by the central bank and private placements by the securities regulator. Source: WIND, S&P Global Ratings.

Companies that tend to rely on alternative, off-balance-sheet financing are particularly vulnerable. This financing segment is retracting due to China's crackdown on shadow banking (see chart 3).

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Chart 3

State owned companies tend to have stronger banking relationships and deeper connections with capital markets. They can more easily turn to bond markets or traditional bank loans to meet refinancing needs. Nevertheless, investor caution is also adding to tougher credit conditions for more vulnerable state-sector borrowers, especially those domestically rated 'AA' or below. For example, spreads of these securities are widening, despite liquidity injections from the central bank (see chart 4).

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Chart 4

Next Challenge: Scaling The Debt Maturity Wall

We expect Chinese policymakers to remain committed to deleveraging efforts, despite expected fallout in the form of increased defaults and bankruptcies. While external factors such as escalating trade tensions may lead to policy fine-tuning, the policy direction will not change in the next 24 months. In the next few months, we expect onshore issuers to face deteriorating liquidity and face restrained refinancing conditions.

Moreover, unique characteristics of China's credit market could multiply the market stress. A significant proportion of borrowing is short term in duration, so companies persistently have to climb maturity walls of worry in China. Onshore credit bonds' maturity amount will reach RMB4.3 trillion yuan in 2018, a little bit lower than 4.6 trillion in 2017. However, the effective maturity amount could rise to RMB5.3 trillion yuan this year, assuming all puttable bonds will be exercised at the first put date (versus RMB4.9 trillion yuan in 2017 if counting exercisable put options).

Besides the puttable bonds, hybrid capital structures could add further stress to refinancing conditions, in our view.

Puttable bonds intensify the liquidity risk

Many investors in China's onshore bond markets have the right to demand immediate repayment at predetermined put exercise dates. The clause also gives companies the option to raise the . In our view, this feature constitutes a market overhang at times of rising investor caution and constricting liquidity. Nearly 60% of investors holding puttable bonds chose to exercise their rights from January to June in 2018 , This is significantly higher than 24% in 2017 and 20% in 2016 respectively.

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More such activity could be on the way. In 2018, investors have the right to put bonds with an outstanding value of RMB1 trillion, an increase of 223% compared with RMB313 billion in 2017. Fromm July 2018, investors have the right to demand immediate payment on RMB110 billion per month for the rest of the year. The first half of 2019 will also be heavy with exercise dates (see chart 5).

Chart 5

According to China-based data provider Wind, 41% of puttable bonds were issued by companies rated 'AA' or below, which in China is considered in the "high-yield" category. As the country's default risk increases, investors may be less willing to hold the debt of riskier companies, and so their willingness to put will be strong, even if the issuer offers to increase the coupon rate to defer the repayment.

We note that the property sector accounts for 26% of puttable issuance, and that more than half of property-sector issuers are privately owned. Overall, privately owned enterprises (POEs) account for a large proportion of puttable issuance. Considering these companies already are having a tough time amid the current refinancing environment, their liquidity challenges could turn severe.

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Chart 6

Hybrid refinancing is another potential risk

China's perpetual may also offer some negative risk surprises, in our view. This market has grown rapidly since 2013, in part because the hybrid-capital instruments can be treated as equity in balance sheets, thus lowering leverage rage. Outstanding perpetual bonds are valued at RMB1.2 trillion. Like elsewhere, China's onshore perpetual bonds commonly give issuers the right to defer interest payments and redeem the securities. For redemption, the first call dates are usually set three to five years after issuance (i.e. 3+N or 5+N). Typically, onshore perpetual bonds are not subordinated to other financing . Issuer that don't redeem generally face step-up rates of 300 to 500 basis points.

Because the large step-up encourages redemption, many investors expect issuers to call the bond when they can do so after three to five years from the issuance date. Effective maturities on perpetual bonds are set to soar in the next few years. This year about RMB68 billion, or 6% of perpetual bonds will effectively mature, with the amount jumping to RMB465 billion in 2020.

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Chart 7

More than 90% of China's perpetual bonds are generally issued by companies with domestic ratings in the higher categories of 'AA+' or above. Also, SOEs accounts for 93% of the total issuance because they have strong motivation to use perpetual bonds to lower leverage on accounting basis to meet the deleverage requirements from government. However, in our view, these bonds should be treated as debt instead of equity considering the high step-up, short effective maturity, and non-subordination nature.

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Chart 8

That said, we believe it would come as a shock to the market if domestically high rated SOEs unexpectedly failed to redeem their perpetual bonds. The same goes if issuers choose to exercise their rights to defer interest payments. Under such circumstances, investors would lose confidence in issuers' capacity to repay debt. This could dramatically weaken issuers' funding flexibility and increase their future funding costs, which in turn would intensify debt-servicing capability for highly leveraged SOEs.

SOE Default Risks Should Not Be Underestimated

China's SOEs have benefitted from rising industrial prices and the preliminary success of supply-side reform to reduce supply glut, resulting in significant improvements in profits and cash flow. Moreover, SOEs often enjoy strong banking relationships and government support.

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Chart 9

However, SOEs may not be immune to China's deleveraging efforts and crackdown on shadow banking. Default risk could spill over from the private to the state-owned sector, given investors and lenders' declining risk appetite, and the surge in maturities (including effective maturities such as bond puts and perpetual calls). On top of the RMB2.96 trillion in SOE bonds that will mature in 2019, some RMB1 trillion in SOE puttable bonds will become exercisable in the year. Should investors sell back these bonds to the issuers, the additional liquidity stress would be substantial.

Moreover, while upstream SOE producers have benefitted from price hikes due to de-capacity policy, the next question is whether downstream demand can hold up. Continuing liquidity deterioration has led to weakening investment and consumption. One reliable indicator of SOE profits is the difference between the producer and consumer price indices (PPI vs CPI). We note the PPI-CPI gap has been narrowing, which may imply that SOE earnings growth will continue to slow in the months ahead.

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Chart 10

LGFVs present a special case with special risks

We think local government financing vehicles are particularly vulnerable to China's deleveraging efforts. LGFVs are often non-profit in nature; their roles are to carry out local government infrastructure, development and pump-priming goals. As such, they generally operate with high leverage and low stand-alone credit profiles, yet are able to access debt markets due to expectations that governments could support the vehicles in the event of stress.

However, the Chinese central government's derisking campaign encompasses LGFVs. In fact, last year authorities decreed that LGFVs cannot put explicit government guarantees in their bond offering documents.

LGFVs accounted for a third of puttable bond issuance as of June 2018, and face a surge in effective maturities (see chart 12). Moreover, LGFV appear to be among the riskiest in the puttable category. For example, 48% of LGFV puttable bonds were issued by platform companies domestically rated at 'AA' or below, compared with 27% of other SOE issuers.

Beginning from July 2018, a large amount of LGFVs' puttable bonds will mature, which will worsen liquidity if these bonds are sold back to the issuers.

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Chart 11

LGFVs also have a large amount of hybrids on their balance sheets, with RMB152 billion perpetual bonds effectively maturing in 2020 and RMB146 billion in 2021. We note that LGFVs issued some 37% of outstanding nonfinancial perpetual bonds.

Chart 12

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China's government will ultimately play a major role in the country's default trends. We believe the government has a higher tolerance for SOE defaults, after allowing SOEs to default on bond repayments in 2015. This is because allowing defaults and bankruptcies could facilitate the country's deleveraging and economic structural adjustments. There's room for higher rates of bankruptcy and defaults, especially for "zombie" companies—those SOEs saddled with losses and unlikely to recover. Although rising, defaults still make up less than 0.5% of outstanding bond issuance. Allowing more defaults would send a message to state-owned companies that defied central-government guidance: Rein in borrowing.

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