20 September 2018
Sinosteel's default on 2 billion yuan worth of bonds means the era of 'rigid payment' is over. Photo: Reuters
Sinosteel's default on 2 billion yuan worth of bonds means the era of 'rigid payment' is over. Photo: Reuters

Why the first bond default by a state firm is a game changer

Some say the biggest bubble in China is in the bond market, not the stock market.

That notion was reinforced after state-owned steel group Sinosteel sought a deadline extension on 2 billion yuan (US$314.9 million) of 5.3 percent notes maturing in 2017.

Also, Chinese authorities have asked bond holders not to exercise a redemption option to force full repayment.

Sinosteel delayed interest payment on the notes just hours before the Oct. 20 deadline, the first bond default by a state-owned steel maker.

The default followed that of Baoding Tianwei Group, another centrally owned state company.

All this means China’s era of “zero default” has ended.

A number of players in the private bond market and the interbank market are also facing default pressure.

Nevertheless, these don’t necessarily presage a wave of majors defaults.

In fact, these troubled state firms have their own problems, leading to a credit crunch.

The industry down cycle has resulted in poor earnings, even huge losses.

Many of these companies are grappling with reduced access to bank loans.

These defaults may heighten investment risk in the bond market but may not lead to systemic failure.

China’s steel sector has been struggling with lackluster demand amid cooling economic growth.

And the whole industry is lumbered with severe overcapacity.

Sinosteel has posted poor results since 2010.

The industry downturn, coupled with operating issues such as excessive expansion and lax internal risk control, caused the defaults.

Investors have to bear in mind that risk and return always go together.

All companies are subject to default risks as we’ve seen in big US companies and with European government bonds.

At present, overcapacity is rampant in China, ranging from the solar industry to the steel sector.

In addition, the prolonged economic slowdown is set to increase credit risk.

Investors should be careful when buying low-grade bonds underpinned by property assets or companies in bloated sectors.

Sinosteel’s default broke the longstanding notion of “rigid payment”.

Investors should know that the credit rating of different bonds will diverge amid an economic slowdown and there is a higher risk of default in certain overproductive sectors.

The financial performance of a company will determine its risk factor in the bond market.

The “rigid payment” culture will continue to shatter with higher risks and more defaults.

This is a painful time for the bond market before it becomes mature.

Most companies would choose bankruptcy or debt restructuring after a default.

However, we always see the government step in and pay off debt eventually in order to stabilize market confidence.

Government intervention merely strengthened the “rigid payment” culture, which means investors won’t learn from their mistakes.

How can institutional investors grow under such culture?

Doing away with that culture is critical to the long-term development of China’s bond market.

This article appeared in the Hong Kong Economic Journal on Oct. 26.

Translation by Julie Zhu

[Chinese version中文版]

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Senior investment banker

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