A Crack in China’s Debt Foundations

Bonds issued by China’s biggest distressed debt asset manager just lost 40% of their value—how concerned should we be?

The most important story in global bond markets over the past two weeks was arguably not the soaring and swooning of the U.S. Treasury market, but the violent 40% sell-off in the dollar bonds issued by China Huarong Asset Management Company.

Readers of our NB Blog page may have seen some commentary on this from my colleague Gloria Lam—but the incident has received much less coverage than it deserves. So, what is Huarong, and why does it matter?

Bad Assets

Huarong Asset Management is China’s largest manager of distressed debt, stewarding close to $300 billion of assets, and is 57% owned by the country’s Ministry of Finance.

Its history is checkered, to say the least. Its former chair was executed in January after being found guilty of corruption. He left the firm’s non-core units weighed down under a mountain of bad assets that regulators and management are now trying to sort out.

Nonetheless, the firm’s core distressed debt business has been delivering stable earnings, which market participants considered enough to absorb the impairments coming from the non-core units.

It therefore came as a shock to those market participants when Huarong failed to file its preliminary annual earnings report on March 31. Rumors that the dollar bond issuer’s onshore parent company might refuse to honor its “keepwell” covenant—an undertaking to sustain it with financial backing—and possibly restructure the bonds, sent the securities into a tailspin.

A Huarong default would be the largest in China’s history, and investors know that in recent, smaller defaults, enforcing these keepwell covenants has been an uphill legal battle. Deliberately breaching such a covenant in this case would send a very negative message to the market—even before it sinks in that the authorities are reconsidering their support for big state-owned enterprises (SOEs).

Keepwell

We have long anticipated a rise in defaults in China, generally, and of SOEs in particular. In December, following defaults from chipmaker Tsinghua Unigroup and Yongcheng Coal & Electricity earlier in the year, we wrote that we expected China’s default rate to converge with that of other emerging markets as the authorities pursue an economy with lower leverage and less moral hazard.

In this case, however, we believe the authorities will engineer a soft landing and the keepwell will be honored. As such a huge owner of distressed assets at the heart of an economy that is likely to experience a rise in non-performing loans over the coming months, we think Huarong’s policy significance is too high for the government to allow any doubt about its stability.

We therefore think the reverberations of the Huarong sell-off have created some value opportunities in China’s fixed income markets. As always, however, we invest with balance-sheet robustness top of mind, based on fundamental research rather than domestic credit ratings, anticipating that a flight to quality can come at any time.

This is especially the case in SOEs, where we also place high importance on ownership structures and policy significance. For example, we consider local government-owned entities to be more at risk from the efforts to reduce moral hazard than those backed by central government—in the case of Huarong, central government is the owner.

Hidden Debt

China’s debt markets have grown in size and importance recently, and although data suggest that inflows have paused in recent weeks, they have attracted a steady increase in international ownership over the past two years, uninterrupted by the global pandemic. Investors have enjoyed attractive returns with modest volatility during this period.

At Neuberger Berman, we remain positive on China’s bond market over the long term, and our Shanghai-based fixed income team is following the situation as events unfold. Not only have fixed income returns been resilient this past year, so has economic performance. GDP is up 18.3% year-over-year, supported by strong industrial output and exports, and retail sales are 34.2% higher, year-over-year.

But the Huarong incident should give prudent investors some pause. Much of China’s resilience not only over the past year, but over the past decade, has been bought by rising debt. China’s central and local government debt-to-GDP ratio of nearly 80% is high, but probably understated, as much local government debt is hidden among SOEs, and especially Local Government Financing Vehicles. Indeed, we think Huarong will be kept solvent precisely because of the probable level of future distress in China’s economy.

China’s authorities are focused on that challenge, but addressing it is likely to uncover more problems in the years ahead and generate more volatility. Any accident would likely have repercussions not only for China’s economy and debt markets, but the wider world’s. It is a situation that warrants close attention.