China Default Angst Flares After Rare Case With Junk Bond
(Bloomberg) -- A rare event in a corner of China’s credit market is fueling concern that more defaults are looming, adding to strains sparked by the government’s crackdown on leverage.
A timber company in the country’s northeast decided this week not to pay off perpetual bonds despite having an option to do so. That was a first for a junk-rated issuer of such securities in China. Firms that raise money with perpetuals never have to pay off the principal, in theory. But in practice, the bonds usually have coupon rates that increase at set dates along with options letting issuers repay the securities to avoid the escalating interest charges.
Companies wouldn’t stomach surging debt servicing costs, the thinking goes, unless they lack the firepower to just retire the whole obligation. And if their finances have deteriorated that much, they may at some point delay interest payments. The concern is acute in China, where firms have turned to perpetuals to reduce debt on paper given that the securities can be listed as equity on balance sheets.
“If a perpetual bond issuer with high credit risks doesn’t repurchase bonds and if bondholders can’t sell the bonds to anyone else, it’s possible that they may have to sit there and watch valuations decrease until the day of default,” said Wang Ying, a senior director at Fitch Ratings in Shanghai. “The event is an awakening for Chinese perpetual bond investors. If you buy a perpetual bond, it can really become perpetual.”
The company this week is China Jilin Forest Industry Group Co., which has a local rating of A+, considered junk in the country. It issued 1 billion yuan ($158.8 million) of perpetuals in 2015 with a 7.1 percent initial coupon and a call option, the first of which is on Feb. 4, 2018. The timber firm won’t exercise that option, according to a statement this week. That means the coupon will increase about 300 basis points.
An official at the firm’s finance department, who declined to give his name, wouldn’t comment on the reason for skipping the call option.
China started allowing onshore perpetual sales in 2013. A total of 8.8 billion yuan has been called, and only one other issuer ever decided to forgo the option, according to Bloomberg-compiled data. Most of the 1.1 trillion yuan of outstanding perpetuals also have cross-default covenants, triggered if the issuer defaults on other borrowings.
As President Xi Jinping steps up leverage curbs, borrowing costs have jumped. Corporate defaults will rise in 2018 as credit tightens, S&P Global Ratings has said. Fitch Ratings estimated more lower-rated perpetual issuers will prefer swallowing higher coupons than buying back bonds given refinancing difficulties.
“It would be hard for an A+ rated company like Jilin Forest to sell bonds” at the moment, said Lyu Pin, a bond analyst at Citic Securities Co. “Liquidity is probably tight and the company doesn’t have enough motivation to buy back the bonds.”
©2018 Bloomberg L.P.