Odd Lots - How Bond Defaults Are Changing China's Markets

Episode Date: December 2, 2019

For years, defaults were few and far between in China's corporate bond market. Most investors thought that the Chinese government would never let companies — whether they be state-owned enterprises (SOEs) or private businesses — actually default on their debt. But times have changed. Defaults by private companies have been rising and there's even a question mark over the implicit government guarantee in debt sold by SOEs. One state-owned enterprise in Tianjin has proposed a 64% haircut for bond investors, in what could amount to the first de facto default by an SOE in more than two decades. On this week's episode of the Odd Lots podcast we speak with Jun Pan, Professor of Finance at Jiao Tong University, about her recent research examining what China's corporate bond prices are actually telling us about the health of its companies and wider economy.See omnystudio.com/listener for privacy information.

Thanks for listening to Odd Lots. Follow the show on Amazon Music for more future episodes or just ask, Alexa, play the Odd Lots podcast on Amazon Music. Thinking about buying the right home, but not sure when. What if you had the right design, the right lot and finishes at the right price? Not someday, but right now. Register at Democrathomes.com and get everything you want right now. And welcome to another episode of the Odd Lots podcast. I'm Tracy Allaway. And I'm Joe Wisenthal. So Joe, you know I just came back from Beijing. Yes, and we haven't even talked about it yet, but I saw all of your pictures, and I'm extremely jealous. Yeah, the food was very good, and you should be jealous because you missed out on quite a lot.

But, you know, I hadn't... You had some lamb thing, like a big, like gigantic barbecued lamb that just looked like the best thing I've ever seen. Is that right? It was so good. It was amazing. It was like a Mongolian barbecued leg of lamb that you grill at your own little table. And then you dip it into crushed peanuts and salt. And it was good.

I'm allergic to peanuts, but everything else sounded amazing. All right. Well, next time you come, we will have that without the peanuts. But, you know, I hadn't been back to Beijing for like 13 or 14 years. And there were so many changes to the city, like really big ones, whole areas of it are just unrecognizable to what they look like in 2005, 2006. I feel like we should do a whole episode at some point, just like you comparing Beijing over 13 years. I bet people would be interested in that.

I don't think I was as financially minded back in 2005 and 2006. But I was going to say one of the biggest changes in that time period has, of course, been to China's capital market. So 13 years ago, China didn't really have much of a corporate bond market. And now it has a pretty big one, both domestically and dollar-denominated offshore bonds as well. But most importantly, China's corporate bond market has had a number of defaults in recent years. And that's a really big change because historically, you know, it was kind of uncertain that the authorities in China would allow companies to default. So you can imagine, Joe, that makes for an interesting bond market, given that bonds are, of course, supposed to reflect investors' perception of default risk.

Yeah, I remember, like, I guess, what was it, 2014 or 2015, the first ever Chinese bond default? And I remember thinking, like, how is this possible? Like, how could you have the first ever bond default? And I almost, like, thought I was misreading the article is this idea that there had never been a defaulted bond before. But obviously, you know, we sort of take for granted the maturity of the U.S. bond market, the U.S. corporate bond market, and then defaults even in good times, you know, they happen from time to time with low-rated companies. We sort of take for granted that not all markets are as mature and sort of market regulated the way the U.S. one is. Yeah, totally. And I mean, I remember in 2015, analysts over at Bank of America, Merrill Lynch, they published a

note that was basically a history of Chinese corporate bond defaults, and there were like two things on there. It was a pretty short note, as you might imagine. But it raises all these interesting questions about how do you actually develop a corporate bond market almost from scratch? And what sort of distortions or unique characteristics are introduced when you have a big question mark over whether or not defaults will be allowed? And I should just say, one of the the defining features of China's sort of business system as a whole is the division between private companies and state-owned enterprises. So SOEs, these big state-run conglomerates that are often thought to be government-backed or even government-guaranteed.

Right. Well, I'm interested in learning more about this topic. All right. So we actually have the perfect guest to talk about all of this. It's someone who's done a lot of academic work on exactly this topic, as well as a lot of other stuff. It's Jun Pan. She is a professor at the Shanghai Advanced Institute of Finance at Shanghai Jiao Tong University. So, June, thank you so much for coming on. Well, thank you so much for the invitation. It's exciting to hear what you and Joe just talked about. It's really an interesting topic for me at the moment. Right. So you actually just published a paper. where you were looking at this exact topic, and specifically you were looking at whether or not

spreads or risk premiums on China's corporate bonds actually reflect the health, the financial health of its companies. But before we dive into that, I wanted to sort of ask you a broader question about how China's financial markets are currently structured. So corporate bonds are supposed to be market-based versus the sort of traditional bank-based system of lending in China. And what I mean by market-based is investors are setting or influencing funding costs by demanding a certain level of compensation for perceived risk. So how big of a leap was it, or is it for China to move from that bank-based system of lending to something that incorporates more market-based types of lending?

I would say it's a big leap. For people like myself who works in a financial research area in the financial markets, this is a very encouraging development to see that China's credit market, overall the credit market to be improving. Actually, the speed of the market's development was pretty impressive. Over the past 10 years, it grew into a roughly 3 trillion U.S. market. So it has been a pretty impressive development just to the credit market alone. So, sorry, break it down. What is the split between how much private credit is funded via

something we'd recognize as the bond market versus traditional bank lending? So if you think about the ratio for non-financial firms in China, so we have a ratio for market-based debt, so including corporate bonds and also. So other type of funds, basically market traded versus bank loans. In 2008, it was about 4.6%. Okay. So only a tiny fraction as a ratio to the bank loans. You know, China's financial system is still a bank-dominated system, not like in the U.S.

So that number grew from 4.6 in 2008 to a little bit under $2.20. 20%, to be more precise, 19% in 2018. And much of that improvement is driven by the corporate, the credit market. Right. So walk us through your most recent paper. So you're taking a deep dive into Chinese corporate bonds, and you're trying to ascertain whether or not the actual spreads, the risk premiums reflect something fundamental about the

financial health of Chinese companies, as they sort of are meant to do in more developed markets. So, you know, if a company is perceived to be at a higher risk of default, it'll have a higher spread because investors want to be compensated for that risk. Why did you decide to look into this particular topic? In the U.S. market, this question has been well researched. So you look at companies of different, let's say, different fundamental risk. in terms of default. In academic, we have standard models named after Professor Bob Burton. We call the murder model.

So in a murder model, we take the firm's balance sheet information, including its leverage. And also, we take the firms, if the firm is traded with publicly listed equity, we take the equity market information. And one of the key information will be the equity volatility. So the murder model would take those fundamental plus equity market information as input and give you an assessment of what's the probability of default for the bond issued by this company. And you can get a sense that there would be a connection between model predicted default and the market observed credit spreads. Right. So in the U.S., if you take an approach of that, you will see that about 40% of the variation in credit spread can be explained by fundamental.

So we take this as a starting point, and we want to see whether in China we see a similar direction in terms of fundamental, house of the firm and the credit market pricing of the issuer. And this is our starting point. Before we get to how well the model works with the Chinese bond market, I'm curious in the U.S. maybe just talk a little bit about, you know, the U.S. is probably close to the sort of ideal free market or free bond market. is the Merton model robust enough such that one can use it to identify mispricings or identify arbitrage opportunities between the price of a bond and the price of an equity?

Because you said 40 percent. So I'm sort of curious whether it's something that's mostly useful from just a pure theoretical perspective or whether it can sort of form the basis for at least initially attempting to identify overvalued or undervalued bonds. Well, this is a good question. I mean, our financial models are always approximation of the much richer reality. But this model actually has been used by practitioners. There is a, you probably have heard of it.

It's called KMV. Yeah. So KMV was a company that took exactly the murder model and feed the model with all the real data. and the outcome is the KMV's distance to default measure, which is similar to a probability of default measure. I think for those listening who have terminals at home, we have a very good function on the terminal where you can enter, see a company's KMV. Yeah, I thought I had to plug the terminal here.

But you can actually, it has the Merton model, and you can change some of the assumptions. And so it's very fun. You can sort of measure the gaps between the price or the CDS, distance to default. You could play around with that. It's very fun. Anyway, I didn't mean to interrupt you. I apologize for that. I always say this model, it's not perfect. Even the Black Show's Option pricing formula has a lot of, you know, limitations.

But it's a good starting point. A good reference point was to start with. And it's encouraging that there is a link between the fundamental of the firm and how it's a bonus price. And as you move on from the U.S. market to the to the Chinese market, you will be surprised or maybe not surprised to see that this link actually should not be taken for granted, as we see in the data. So imperfections in the Merton model aside, what did your research actually show for the Chinese credit market? Did spreads on China's corporate bonds actually show some sort of link to the fundamental health of companies or issuers? I mean, I guess another.

way of asking that question is, is the market-based system actually working in China? So this question has a no and then a yes. So the no is that before 2014, as you and the judges discussed, before 2014 bonds were not allowed to default. So they were zero default. So prior to 2014, so our data was from 2010 to 2014. We call this phase one, period. during that period, there is no link. Fundamental and accredited spread, there is no link between those two. Why wasn't there? This idea that there were like, there was questions about whether a default would ever be allowed to happen. What was the fear there and what was sort of then driving the market if there was this perception that defaults just weren't going to be a thing?

Well, first, let me actually rephrase my previous statement. I should say conditioning on information in ratings because China does have rating agencies. So they do rate these different bonds. So conditioning on the ratings from fundamentals have no additional information. So there is no link. I do want to qualify my previous statement. In terms of why defaults were not allowed to happen, I guess this is not something, it's difficult for me to speculate on the regulation

regulators side. But the observation from the market participants is that these bonds never default. So there is the Chinese saying of bond market pricing was face-based. So you hold on to this phase that bonds don't default. So it doesn't really matter about risk compensation because the debt's going to get bailed out anyway

if it ever ran into trouble. And hence, there's actually no. differentiation shown in the risk premiums that is actually connected to the fundamental health of the company. But you said that was phase one. So what happened in phase two? Okay. So we start our phase two from from 2014 after the first default. So from phase two to the first quarter of 2018. So over that period, you started to see a connection. between the firm fundamentals and the equity market information and the, what do you call the risk premium of this bond,

or credit spreads of this bond. They start to develop a link. The link is much weaker than what we see in the U.S. market, but this is from our end. It looks like a very promising beginning for the Chinese credit market. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute.

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beginning in the intro, of course, the Chinese private sector or the Chinese corporate market is still segmented massively between regular enterprises and state-owned enterprises, which are state-controlled and state-backed to varying degrees. You also look at what the bond market says about the state-owned SOE sector. What do you see are the differences in terms of how the bond market works for those SOEs? So during phase one, which is prior to the default, there is not too much differentiation between these. two groups. Overall, we do see that SOE, this government

sponsored enterprise, the SOE is a state owned enterprise. You know, depending on how you call them, let's just call them SOEs. So during phase one, SOE does have a little bit of a premium, meaning that their credit

spreads are narrower compared to the non-SOE counterparts with similar ratings. During phase two, If you remember, phase two was the time from 2014 to 2018 when we started to see defaults. But the defaults happened during that time was mostly to the non-listed firms. So if you focus on the listed firms, meaning that these firms usually are larger firms in the economy, then the difference between SOE and non-S-O-E are still are pretty mild, mild in the sense that during phase

three, later on they become explosive. But during phase two, there was still about 20 basis point in terms of difference in the credit spread. Let me rephrase. The SOE issuers enjoy about a 20 basis point, narrow credit spread compared to that they're not as we counterpart. So the implicit guarantee seems to be very much alive for. the state-owned enterprises, and so they have these lower risk premiums, which means they can

attract financing at a lower cost than private companies. I'm wondering, do you have any thoughts or insights into how the Chinese authorities might be viewing that discrepancy or that segmentation in the market? Like, is there a desire to put private companies on a more even funding footing, so to speak, with SOEs. Is that something that China wants? May I complete the whole picture before I talk about what policy implications is? So prior to 2018, so far we have two phases. One is pre-defort, one is post-defort, but up to 2018. You look at the data, the difference between SOE and the non-S-OE is mild. It's about 20 basis point of a premium for the SOEs.

But going into 2018, this is when the credit market went crazy. So there are different regulations. Even prior to 2018, there was a de-leveraging campaign that started in 2017. So gradually, the credit market was affected by the regulations. Especially in 2018, there was a what they called the asset management, new regulations on asset management, which kind of cut the funding from the asset manager's side, cut their holdings of the credit bonds. Or put it another way, it makes them more discriminating against the, how should I say, makes them more aware of the credit risk, even more so than before.

So this is the time when the segmentation become very severe. So the 20 basis point premium enjoyed by the SOUs exploded to about 100 basis point. Prior the segmentation between these two markets was not so severe, then post-2018, it became a really big deal. And along the same time, you see, starting to see a lot more defaults for the non-SOE. you funds. So it sounds like just listening to you so far as you identify these three phases. So there's the pre-default phase going up to 2014. Everyone enjoyed pretty tight spreads. The bond market didn't tell you very much. Post-2014, you start to get slightly more wider spreads for the private, non-SOE companies, and more information from the bond market period.

The prices start being more informative. Post-2018, the spreads get even wider. And in this phase, this is due to asset managers being forced to be more cognizant about credit risk. It sounds like sort of just an ongoing maturation process. There was a story, and Tracy alerted it to me this morning that actually there is an SOE now that it's very close, if not near, in default. There are some sort of bondholders are going to have to take a haircut. Are we on the verge of a new stage four or a phase four whereby the bond market will start to be more meaningful for also the SOE sector?

The private SOE is you see them, you actually see private listed, when I say private SEO, I mean, SOE issuers who do not have publicly listed equity. So for this group, we actually have seen the thoughts among this group. I want to go back to my earlier question, which was about whether or not it's desirable for the private companies to be on a similar. funding playing field as the SOEs. Because of course, in order for that to happen, I guess you do need to introduce some sort of default risk into the state-owned enterprise sector, or you have to eliminate it in the private market, which doesn't seem to be what China wants at the moment.

So is leveling the playing field between those two sectors when it comes to financing, when it comes to moral hazard in the bond market, is that something that's desirable for China? It's something desirable, but I just don't see how that would work in this corporate bond market. If you put them together, the SOE has explicit or implicit government guarantee, while the non-SOEs have none. During come periods, investors are not discriminating against the NIOEs. But starting at phase three when you see massive

defaults, not massive, but you see increasing amount of defaults happening in the market, then investors are nervous. When they are nervous, they shone away from the NIOE issuers. Most of them

take only SOE bonds and they just lock up, lock, lock that NOSOE bounce out, but they don't even look at NOSOE bounce. That's the problem. And I just don't, at the policy level, it would be difficult to find a way to level the playing field for these two groups, especially during crisis. Speaking at the policy level, I want to sort of ask a big picture question.

So you mentioned that for, through most of history up until very recently, the Chinese economy, most credit was bank credit. And there wasn't even really much of a bond market if you go back a little bit over a decade. How much of that bank led market is especially by design whereby authorities who have sort of priorities in terms of investment can more easily direct bank lending. And I'm curious if the ongoing growth of the credit market as a means, is a vehicle for financing, changes at all the ability of decision makers of political leaders to direct money towards key favored industries or whether that hasn't really changed much, whether they can still do it except just through a different avenue.

I think having the market-based corporate bond market is very important to direct, especially direct funding financing sources for the, non-S-O-E. I see. Because prior to that, bank funding was mostly directed at SOEs. Right. So, SOE banks led into SOE firms. So for the non-S-O-E, this credit market is actually very important. And up to 2018, they enjoyed increased issuance.

They enjoyed financing. But post-2018, as the market was going through, very stressful periods, their funding process actually dried. I shouldn't say dried up, but they were decreasing steadily. So new issuances by non-SOEs as a fraction of the overall market decreased in the first quarter of 2018. So we've talked a lot about, I guess, the sort of uniqueness of China's corporate bond market at this current moment in time. And in many ways, it's still developing and maybe it'll get to a similar level to where the U.S. is at the moment, but it's not quite there yet.

What do you think this means for international investors? Because, of course, China's corporate bonds are becoming more integrated into international investors' portfolios via inclusion in benchmark indices, including some that are owned by Bloomberg LP, I should just mention. So what does all of this mean? for international investors, how should they be viewing China's corporate bond market at the moment? China's fixed income market overall is being opening up. You see a lot of relaxing of restrictions that very much welcome the international investors. Corporate bond in particular,

I think most of the foreign investment right now is focused on the yield space, not the spread space, meaning that it's focused in most of the government bonds, but you would say the default-free bond, not the credit bond. But overall, I think this market would benefit from more international investors. Or conversely, maybe there would be opportunities for international investors to pick the right bond. To put it differently, I think,

for international investors, these companies that issue corporate bonds, these are, especially for the sample we studied, these are large companies with listed equities. So this could be another way for them to be exposed to the real China in a sense that these are companies doing business in China. Jin, that was a fascinating conversation and a really good time to have that conversation given what we've just seen in China's credit market. So thank you so much for coming on. We really appreciate it. Thank you. That was great. Sure. Thank you. I found that conversation so, so interesting. And one of the things I always like about, you know, markets and financial regulation and the development of capital markets is the idea that there can be all these unintended consequences. So I'm really fascinated by the idea that by introducing the possibility of default into the

private market, China has basically inadvertently created this big funding cost segmentation, but also kind of created a potential financial stress point, like the notion that when things get really bad, everyone flees the private companies and heads into the SOE sector. I find that really interesting. Right. I mean, I guess the thing is, at some level, there's going to be, it's hard to imagine the existence of SOEs and they're not being a major slanted playing field or tilted playing field on some level. Like whether there's a bond market or a stock market or whatever, the fact that a bunch of companies are state-backed and a bunch of aren't, you'd imagine that that's going to create an advantage for the state-backed ones. But to see how that sort of manifests itself and to even like

sort of wrap ones head around the idea of market-based pricing of state-owned enterprises, it's just extremely strange. And it'll be interesting to see how that developed because if it stayed-backed, why would they let it default at all? I don't know. It's very, it's kind of hard to wrap one's head around from this sort of U.S.-centric perspective. Right. So you definitely have questions around this. And that company that you mentioned, the state-owned enterprise, it's called Tewu. And it's potentially sort of defaulting on its dollar bonds. This is a big SOE that's based in Tianjin, which is in the northern province and has been experiencing a few economic problems. So this is going to be a really interesting one to watch, like whether or not this becomes a watershed moment for. for SOEs. And again, the policy implications are absolutely fascinating. Is this something that China is actively trying to encourage in order to introduce more differentiation between its SOEs? Or is this something that it doesn't actually want to happen, but it's starting to have to

countenance the idea of haircuts or defaults because of its massive debt load and fiscal position? That's sort of the question that we are in. Yeah, and just more generally, I really like the way she broke it down through the different phases because, again, I mean, this is obviously just such an incredibly immature market. It's basically existed for a little over a decade. So I'm sure there will be more phases to come, but so far what we've seen looks like what you would expect from a sort of maturing growing industry or part of the capital markets. And if you think about how young, it is, it kind of makes sense that they never had defaults in the beginning because you sort of, you know, you want to build up an investor base. You want to have people have confidence in the market overall. So you sort of get the impression, the sort of liberalization of the market. It's slow, but it's also kind of logical. Right. I mean, there's definitely teething problems that you would see in any new capital market. But I do think the picture is complicated by the structure of the Chinese economy and the existence of the SOEs. And it's sort of, um, It's sort of capital markets with Chinese characteristics, right? Well put. Thank you. All right.

Well, this has been another episode of the Oddlots podcast. You can follow me on Twitter at Tracy Alloway. And I'd like to just give a shout out to Steve Ho, who's on Twitter, and he actually suggested Jun for an oddlots guest. So you can follow Steve at Steve Ho. That's H-O-U and then F. Steve Ho F. And I'm Joe Wisenthall.

You can follow me on Twitter at the stalwart. And be sure to follow our producer on Twitter, Laura Carlson. She's at Laura M. Carlson. And follow all of our podcasts at Bloomberg at The Handel at Podcasts. Thanks for listening. The news doesn't stop on the weekends. Context changes constantly. And now Bloomberg is the place to stay on top of it all.

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