Why Hedging Credit Risk Is Getting Easier in China
(Bloomberg) -- A record pace of bond defaults and increasing corporate-funding strains have spurred China’s regulators to re-energize efforts to provide investors with ways of hedging risk in the world’s third-largest debt market. While credit-default swaps, which allow traders to place bets on a company’s -- or a collection of companies’ -- creditworthiness have been around for decades in developed nations, such securities are rare in China. Regulators are now actively supporting financial contracts that let investors make bets on risk. The thinking: that might make them as a group more comfortable buying bonds.
1. Why does China need a credit-risk market?
Up until recent years, it didn’t. The country first started letting companies default on bonds in 2014. Regulators have come round to the idea that only by allowing insolvent borrowers go under can they achieve the objective of pricing credit on the basis of risk, rather than relationships -- which ultimately will limit the build-up of bad debt. What started as a trickle has become more of a steady stream: There has been some 75.6 billion yuan ($11 billion) in defaults this year. But now that defaults are becoming a regular feature of the landscape, investor appetite for bonds could be dented, and all the more so with the economy slowing. An active market for debt insurance could help sustain demand for the underlying bonds.
2. So what’s available?
Market players say credit risk mitigation warrants are the most commonly used of the four main types of instruments in China. They offer a kind of insurance linked to a specific bond or loan obligation, and can be traded on the secondary market. (That makes them different than the Chinese version of credit-default swaps, which were introduced in 2016 but cannot be transferred from one investor to another.) A drawback is that the warrants only cover one specific obligation. CDSs by contrast provide protection against multiple credit events from a single borrower. CDSs in China involve genuine bilateral contracts, with the seller and buyer negotiating price and other terms privately -- limiting their availability.
3. Anything else?
Two smaller tools are credit-risk mitigation agreements (like the warrants but non-transferable) and credit-linked notes, a more complicated transaction that’s bundled with a CDS and hasn’t caught on. What’s not to be found are index-linked credit derivatives, which are popular outside China as they let investors bet on a whole basket of borrowers.
4. Who are the main participants?
Banks are the main sellers of credit-risk mitigation instruments, with some 47 approved to do so. Some brokerages are also active. Banks, investment funds and brokerages are on the buy side.
5. What are authorities doing?
While specifics are pending, the People’s Bank of China made clear in October that it’s looking at ways to encourage risk management in the bond market. The central bank said it will itself grant funding to financial institutions to offer credit-risk mitigation tools and enhancements that make it easier for their customers to issue bonds. By first pumping liquidity into state-owned China Bond Insurance Co., the PBOC hopes to unleash as much as 160 billion yuan in support for risk hedging. There are signs that investor anxiety is easing, with some stressed companies seeing improved access to the debt market. Chemical producer Zhejiang Hengyi Group Co. cut its financing costs at a sale of three-year bonds, thanks in part to credit-default swaps being sold.
6. Any roadblocks?
Perhaps the biggest damper is a relative dearth of liquidity in the bond market itself. While China’s debt securities are enormous, at more than $11 trillion, the country lacks the kind of trading incentives and infrastructure found in the U.S. or Europe. With the fund-management industry still in its early stages, banks own the vast majority of bonds. And they aren’t as active in lending out their inventory to those who might want to make short bets. The debt-rating industry is also a work-in-progress. That all makes it tougher to establish accurate pricing of derivatives tied to credit quality. Though ChinaBond, a state-owned settlement service provider, started to offer valuations for credit-risk mitigation tools in October, the lack of a well-functioning auction mechanism makes it a difficult mission.
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