China’s Corporate Crackdown Adds to Junk-Bond Distress

The latest Chinese market to buckle under pressure from Beijing’s wide-ranging corporate crackdown: junk bonds.

Companies from China make up the bulk of Asia’s roughly $300 billion high-yield dollar bond market, thanks to a surge in borrowing by the country’s heavily indebted property developers. But the investor optimism that drove that borrowing has collapsed.

Stress has been building following a string of debt defaults and growing concern about a few large issuers, including property giant China Evergrande Group. Sharp price declines in its bonds and those of a few other large Chinese companies, plus concerns about tighter regulation aimed at reining in speculation and soaring housing prices, have pushed the market over the edge.

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“There’s a confidence crisis in Chinese high-yield debt,” said Paul Lukaszewski, head of corporate debt for the Asia Pacific region at Aberdeen Standard Investments in Singapore.

The average yield of non-investment-grade U.S. dollar bonds from companies in China topped 14% in late July and early August, around 10 percentage points above the average yield of junk bonds issued by American companies, according to ICE BofA Indices.

The gap between the two recently hit its widest level in a decade, showing how far prices of Chinese bonds have fallen relative to their Western counterparts. Bond yields rise when prices fall.

Many American debt issuers have benefited this year from the Federal Reserve’s easy monetary policy, which has kept interest rates low to spur growth as the U.S. economy rebounds from the coronavirus pandemic. China’s economy, in contrast, returned to expansionary mode last year, and Beijing has resumed a campaign to reduce debt levels in sectors such as real estate, which has put many developers in a tight spot.

China’s Corporate Crackdown Adds to Junk-Bond Distress
Photo: Lam Yik/Bloomberg News

The widening regulatory crackdown that sparked a big selloff last month in the shares of internet-technology and education companies has also weighed on Chinese credit markets, pushing down prices of even investment-grade bonds. The moves show China is getting more serious about reining in companies whose business practices are seen at odds with national priorities. Investors are now actively looking for sectors that might be next in the crosshairs.

“A lot of the tension is focused on the property sector, and it’s really been driven by [China’s] policy,” said Sheldon Chan, an Asia credit portfolio manager at T. Rowe Price in Hong Kong.

Regulators in the country late last year demarcated debt boundaries dubbed the “three red lines” for real-estate developers, requiring them to bring down their leverage before taking on new debt. Government officials have also rolled out numerous measures to curb speculation by home buyers and slow increases in residential property prices that had benefited many developers.

“The three red lines policy is proving effective to push developers to reduce debt, and cutting access to funds,” Mr. Chan said. “Along the way, some accidents will happen and some developers will run into default, which may bring some contagion and volatility,” he added.

Cash-strapped Evergrande—one of the country’s largest real-estate companies and its biggest junk-bond issuer—took on large sums of debt to help fund the building of residential properties in many cities across China. In June, it reported the equivalent of $88 billion in interest-bearing debt onshore and offshore. The company has more than $16 billion in U.S. dollar debt outstanding, according to S&P Global. Some of its dollar bonds are trading below 50 cents on the dollar.

Evergrande on Tuesday said it is in talks to sell some prized assets to raise cash, helping to lift its stock and bond prices. S&P this month cut Evergrande’s credit rating to CCC, saying the company’s liquidity is deteriorating more quickly than expected.

Its financial troubles have spilled over into the bond prices of other developers. One indicator of the extreme market dislocation is the average spread on Chinese bonds with single-B credit ratings.

That spread, or the additional yield these bonds pay over comparable Treasurys, was recently near 17 percentage points, according to Bank of America Global Research, even wider than it was in March 2020, near the height of the Covid-19 outbreak in China.

“It’s overdone,” said Aberdeen’s Mr. Lukaszewski, adding that the spread implies investors are expecting a 30% default rate. “This much negativity in prices is rare,” presenting an opportunity for investors who can figure out which companies will be able to weather the storm, he said.

While prices recovered slightly over the past week, many debt securities are still trading at deep discounts to their face value. An ICE BofA index that tracks Chinese high-yield debt is down 8.4% this year on a total-return basis.

For a long time, defaults among Chinese companies were few and far between, and many investors expected the government to step in and prevent large companies from failing and causing their bondholders to lose money.

That is no longer the case, as authorities in the country have shown a higher tolerance for corporate failures among state-owned and private enterprises. Recent defaulters have included a major real-estate developer, a state-backed chip maker and a coal producer.

In the past, the high-yield debt market has snapped back relatively quickly—as it did after the deep dive in corporate bond prices in March last year—benefiting both companies and investors. This time, however, market participants are hesitant to bet on a fast recovery.

“If there’s no clarity on a turnaround story, it would be brave to stick your neck out,” said Sandra Chow, co-head of Asia-Pacific research at CreditSights. The firm is expecting China’s real-estate companies to report unimpressive first-half results in the coming weeks. “The market is cheap, but it could get cheaper,” Ms. Chow added.

Write to Serena Ng at [email protected]

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