Chinese bond default – What does it mean for Asia's bond market development?

Published on Tuesday, 11 March 2014

Published by Thiam Hee Ng on Tuesday, 11 March 2014

Spread between the 1-year AAA and BBB+ corporate bond yields in PRC. View <a href="/sites/default/files/chaori-chart.png">chart</a> in full.
Spread between the 1-year AAA and BBB+ corporate bond yields in PRC. View chart in full.

Last Friday, 7 March, 2014, Shanghai Chaori Solar Energy Science and Technology Co Ltd defaulted on its 1 billion yuan ’Chaori-11 bond‘ issued in 2011 when it failed to pay in full the coupon due that day.   The company had previously narrowly avoided default in January 2013, after banks agreed to defer claims for overdue loans, allowing Chaori to meet its bond interest payment.

The default should not have taken investors by surprise as the company has been struggling over the past few years due to general weakness in the solar panel market. In 2013, Chaori reported a net loss of 1.33 billion yuan, its third annual loss in a row.

While Chaori’s debt obligations are tiny relative to the 27 trillion yuan People’s Republic of China (PRC) bond market, the default is notable for being the country’s first in the onshore bond market. Other companies such as LDK Solar and Suntech Power Holdings have defaulted but on their offshore bonds.  The PRC bond market is taking the default in its stride. The impact is seen mostly on lower rated bond yields. While yields on AAA rated corporate bonds have remained relatively stable, we have witnessed rising yields on BBB+ rated bonds. The ’Chaori-11’ bond was originally rated AA by Pengyuan Credit Rating but had several downgrades since. It was last downgraded to CCC in May 2013. At issuance it carried a coupon of 8.98% which is 380 basis points higher than AAA rated bonds of similar maturity.

Chaori’s default can be seen as a positive development for PRC’s bond market. It sends a message to domestic investors that bonds are not risk free instruments with an implicit government guarantee and that investors need to be aware of the risks. Allowing Chaori to default could be seen as a move by the authorities to encourage investors to price credit risk more carefully rather than relying on the implicit government guarantee.  Investors need to understand that higher returns offered by bonds with lower credit quality come with a higher risk. As the volume of corporate bonds grows, the government may be wary of being seen as an implicit guarantor.

The default, though, is unlikely to have any repercussions on Asia’s bond markets. There are no direct effects on financial institutions in the region as most investors in PRC bond markets are domestic financial institutions. The small size of the issuance also means there is little likelihood of a systemic impact on the country’s financial system.

As news of the default was emerging, the 7-day fixing repo rate (a measure of funding stress) rose to 3.53% on 4 March from 2.78% on 3 March. However, the repo rate came down soon after that and ended the week lower at 2.40%.  Even if there are other defaults in the solar energy sector, the impact is unlikely to be large.  Total outstanding bonds of PRC companies engaged in renewable energy is roughly CNY139 billion, or just 1.6% of the entire corporate bond market.

The region’s bond markets may even benefit from the default. Moving forward, we are likely to see investors demanding higher yields for lower quality corporate bonds. This may encourage PRC companies to be more adventurous and issue more bonds outside the country as the benefit of an implicit government guarantee for issuing bonds at home is no longer there.

It could also give a further boost to the offshore renminbi market as PRC companies more actively seek funding overseas. As domestic investors reassess the credit risks in PRC we might also see funds flowing to other regional bond markets.