Rocky Ratings in China

Around the world, central banks continue to cut interest rates and buy bonds to stimulate their sluggish economies. China is no exception to the monetary policy trend, with the People’s Bank of China cutting rates seven times since late 2014.

But here’s the twist: Whereas for most corporates, borrowing costs have been falling in lockstep with central bank moves, a recent spike in defaults has left investors in Chinese corporate bonds on edge. At a time when the cost of money has been in free fall, the cost of borrowing for Chinese corporates is going the opposite direction.   Indeed, there are signs that a complete re-rating of Chinese corporate borrowers is upon us, as investors grapple with the creditworthiness of the country’s corporate borrowers as a whole. Bad news from one company is suddenly potentially bad news for all. In April, headline-making debt repayment problems by a government-owned railway supply company resulted in a widening in spreads even for highly rated borrowers. Lower-rated companies were hit even harder, with the spread between AA-rated and AAA-rated five-year notes climbing to a four-year high earlier this month.   Credit Suisse’s Global Markets team thinks this might just be the start of something bigger.

The Bank believes that Chinese corporate borrowing costs have further to rise. The simple yet sweeping argument: The creditworthiness of China’s largest corporations has been systematically overstated and bond ratings are due for a massive correction. As is usually the case, it took an economic slowdown to reveal the cracks in the foundation. While most issuers rated AA or higher have retained their longtime ratings from Chinese rating agencies during the country’s economic slowdown, outside observer(s) such as Standard & Poor’s aren’t quite so sanguine about those issuers’ prospects. In one sample analyzed by Credit Suisse, 17 out of 23 companies rated AA or higher by Chinese ratings agencies were rated BBB+ or lower by S&P.   Why the discrepancy? Chinese rating agencies have as one of their fundamental assumptions that the country’s government will bail out troubled corporations — via a so-called soft guarantee. But given the escalating number of bond defaults in China, the soft guarantee seems little more than a soft suggestion at this point, and there also seems to be no rhyme or reason for when and if the government does actually intervene to help a struggling issuer. Sun Xuegong, an official with China’s National Development and Reform Commission, said last month that the government would help companies with “good prospects” but not “zombie” companies, Bloomberg reported. Simple, right? Not exactly.   Consider the country’s state-owned enterprises, or SOEs, which were long believed to be the most likely to receive government assistance in times of trouble. As of May, four SOEs had defaulted on their bonds.

The first Chinese SOE default came in April 2015, when Boading Tianwei Group, an electric transformer maker, missed an 85.5 million yuan ($13.8 million) interest payment. The company filed for bankruptcy that September. Whether SOE or not, more are coming: As of mid-June, borrowers had defaulted on 32 corporate bonds in 2016, higher than the total for all of 2015.   This year’s biggest shock to China’s corporate bond market stemmed not from a default, but from the possibility of one. In April, China Railway Material Company, a subsidiary of the government-owned China Railway Materials Group, requested that regulators halt trading of its bonds and announced that it would negotiate to restructure its debt. China Railway did ultimately receive a bailout of sorts: A different SOE took over the firm and made a timely bond payment. But by the time of its rescue, the damage had been done: Borrowing costs had spiked across-the-board and issuers cancelled tens of billions of yuan worth of planned bond offerings. In May, the cash flow from bond repayments exceeded the cash flow from bond issuance for the first time since 2010. Meanwhile, two major Chinese rating agencies that had once rated China Railway’s debt at AA+ and AA-, downgraded the company to AA- and BB+, respectively. In 2016 so far, Chinese rating agencies have downgraded some 500 bond issuers and some 90 bonds.  

In an attempt to determine which credits are most exposed to a re-rating, Credit Suisse analyzed 67 bond issuers with market capitalizations of more than $2 billion. Though credit ratings are typically determined based on an array of factors, the Bank’s analysts simplified the process by considering just two in their determination of a theoretical “new” credit rating: a company’s EBITDA coverage (a measure of how long their profits could pay off interest expenses) and net gearing (a ratio of debt to shareholders’ equity). In every case, Credit Suisse gave the borrowers lower ratings than Chinese rating agencies did. The Bank’s analysts estimate that companies’ interest expenses would rise an average of 5.5 percent and pre-tax profits would decline by an average of 3.2 percent in the event of a ratings “normalization.”   Energy and materials companies with weak earnings due to low commodity prices and oversupply issues are the most vulnerable to higher borrowing costs, and the hardest-hit companies in each sector could see profits decline 42 percent and 85 percent, respectively. On the other end of the spectrum, real estate and health care companies, which could see interest expenses rise as much as 18 percent, would experience below-average profit declines due to their strong earnings.  

Credit Suisse analysts say that the second half of this year will be especially challenging. Corporate bonds worth 538 billion yuan and 540 billion yuan are coming due in the third and fourth quarters — far more than in the eight quarters that follow. Refinancing is going to be tricky, particularly for firms in struggling commodities industries such as aluminum, steel, coal, and cement. If companies find the bond market too unwelcoming, they may turn to bank loans, though they’ll face higher interest expenses there, as well. And then they will turn to the Chinese government. Whether they find open arms or a cold shoulder remains to be seen