Impact of Credit Bond Default Events on the Bond Market

The recent default of a state-owned enterprise (SOE) bond in Henan Province has become the most discussed topic and risk point in the market. Looking back at the development of the bond market over the past few years, key events include the 2014 new regulations on repurchase by China Securities Depository and Clearing Co., the 2016 wave of defaults among companies with overcapacity, the 2018 wave of defaults among private enterprises, and the breaking of the implicit guarantee by a regional bank in 2019. Compared with previous credit events, this default incident shares many similarities with the 2019 event where a regional bank broke its implicit guarantee.

The biggest commonality between the two events is that they shattered the market's previous belief in the 'implicit guarantee' for specific industries or types of enterprises, necessitating a reevaluation and repricing of the credit assessment system. The second similarity is that both events occurred quite suddenly, far exceeding market expectations. The third similarity is that the investors involved were relatively dispersed, leading to widespread impacts from the credit shock. The fourth similarity lies in the heightened concern over whether similar entities might also face credit risks in the future. Based on these similarities, we are again witnessing a series of chain reactions in the bond market reminiscent of those following the breaking of the implicit guarantee in 2019. Currently, the bond market’s concerns about subsequent impacts mainly focus on two aspects: 1. How to assess the overall risk in the credit bond market going forward? 2. How long will the tightening liquidity situation caused by pessimistic sentiment last?

I. Review of Default Incidents Involving Key Provincial SOEs

Since October, several key provincial SOEs have exposed substantial credit risks. Following this default, the valuation and trading yields of outstanding bonds issued by related entities and those with similar characteristics have significantly increased. There has also been an increase in cases of canceled issuances and prolonged book-building periods, primarily concentrated among coal enterprises in Shanxi Province. Due to unexpected developments and growing concerns over the willingness of enterprises, or even local governments, to repay debts, along with fears of a liquidity crisis, bonds of relevant entities and those with similar traits have faced sell-offs in the secondary market.

From a fundamental perspective, these companies have long-standing issues such as poor operational performance and heavy reliance on refinancing. However, the significant impact of this risk event on the market does not stem from discussions around company fundamentals but rather from inadequate expectations of default, which triggered concerns over diminished repayment willingness. Additionally, the extensive holdings amplified the scope of the impact, potentially leading to a greater widening of credit spreads. Typically, defaults within expected ranges do not cause market tension or panic. For example, the substantial premium adjustment and extension of a perpetual bond issued by another coal enterprise in Henan did not spark widespread market discussion, mainly because of its low importance and the fact that it was the only perpetual bond issuance. Exiting the bond market through extending the perpetual bond was foreseeable. However, this default event fell outside the expectations of most investors. Firstly, from an operational standpoint, this is not the worst period for the enterprise. Secondly, this enterprise is not the weakest subsidiary within its group; on the contrary, it is one of the better-performing subsidiaries, making its default exposure unexpected. Moreover, Henan is not a typically weak province, and in October, the Henan provincial government issued documents reflecting continued support intentions and actions. Therefore, it is evident that this default far exceeded market expectations.

Looking at the evolution post-default, the domestic bond market appears generally pessimistic. The broad impact of this default and investor concerns over declining repayment willingness from issuers and even local governments are not conducive to the future development of the market. In the short term, from a valuation perspective, the decline in bond valuations has led to a drop in net asset values of asset management products, triggering passive redemptions and further negative feedback. Coupled with stricter institutional entry standards, and even blanket measures against certain regions or industries, this will exacerbate upward pressure on interest rates and widen credit spreads, creating a negative feedback loop on liquidity. From a refinancing perspective, weakening bond demand and increased financing difficulties for enterprises with similar characteristics are highly probable, raising repayment pressures.

When liquidity can be alleviated mainly depends on the subsequent stance of the central bank and the dynamics of local governments. Solely from the perspective of total liquidity provision, the central bank can increase liquidity injections to ease funding strains. On Thursday and Friday, the central bank conducted net OMO reverse repo injections totaling 250 billion yuan for a 7-day term, demonstrating its intention to actively support the market. However, the transmission effectiveness of the central bank's total injection to lower levels still depends on the recovery of confidence in the credit bond market. If we refer to the aftermath of similar incidents in the past, even if there is sufficient total liquidity, stratification of liquidity may intensify. A reduction in the pledge rate of credit bonds, combined with higher risk control standards by financial institutions, could lead to an increase in financing costs for non-bank institutions. During the handling of previous similar incidents, the central bank employed targeted tools and window guidance to provide relief, including incremental MLF targeting small and medium-sized banks and increasing rediscount and standing lending facility quotas. However, in this incident, the role of some targeted tools might also be limited since the affected parties are not small and medium-sized banks; liquidity is more impacted indirectly rather than due to a breakdown in its own links. Therefore, in this case, if the central bank's liquidity injection is to be effectively transmitted downwards, it largely relies on the recovery of confidence in the credit bond market. The central bank's liquidity injection can only address the symptoms, not the root cause, which requires guidance from local governments and possibly higher authorities. Even if the liquidity market returns to normal, the spread between future financing rates will widen, and investors will inevitably place greater emphasis on the fundamentals of SOEs.

II. Reflections on the Medium- to Long-term Impact of Default Events

Regarding this state-owned enterprise default event, the short-term impact has already become relatively clear, mainly due to the decline in risk appetite triggering price drops in associated credit bonds. This, in turn, led to a decline in the net asset value of asset management products holding these credit bonds, prompting redemptions. Consequently, institutions sold highly liquid bonds to meet redemptions, further creating negative feedback.

Historical experience shows that impulse shocks triggered by such credit events will not last indefinitely. As the selling pressure of these credit bonds eases, even without active regulatory intervention, the market is expected to stabilize in a short period. Particularly for government bonds, although they may face liquidity shocks in the short term, their fundamentals have not changed significantly. Therefore, interest rate bonds are likely to be the first to stabilize and rebound.

From a macro perspective, the core logic behind this credit event shock continues to reflect the ongoing differentiation and stratification of liquidity. Since the deleveraging campaign and crackdown on shadow banking began in 2017, financial markets have seen a decline in risk appetite, making it difficult for private enterprises and economically underdeveloped regions to secure financing. Last year's regional bank incident further exacerbated financing difficulties for small and medium-sized banks and non-banking institutions. This liquidity differentiation and stratification has been strengthening over recent years without reversal. For example, provincial distribution of new social financing shows liquidity increasingly flowing into economically developed areas (such as the Yangtze River Delta and Pearl River Delta), while economically underdeveloped areas (Northeast, Northwest, Southwest) receive a declining share of liquidity. Henan Province, where this credit event occurred, also has one of the highest fiscal deficits among provinces. Therefore, from a medium- to long-term perspective, investors need to observe whether weaker regions have sufficient and effective policies to reverse this regional liquidity differentiation. Without such policies—like the top-level design reforms in 2016 aimed at repairing and reversing fundamental imbalances in oversupplied industries—this differentiation could intensify, leading to further shocks.

Fund Strategy

$Da Cheng Total Return Bond Fund (HK0000519014.MF)$
$Da Cheng Total Return Bond Fund (HK0000519022.MF)$

● Strong credit research capabilities effectively avoided this credit risk event

Dacheng Fund boasts an outstanding fixed-income investment and research team domestically. The fixed-income group was established in 1999 and is one of the earliest fund companies to engage in bond investment research. Their fixed-income investment capabilities span five categories: money market funds, pure bond funds, primary bond funds, secondary bond funds, and mixed funds. Dacheng International has deep roots in overseas markets with over a decade of profound understanding and experience; its US dollar bond team averages over ten years of investment experience. The dedicated offshore US dollar bond research team covers macroeconomics, interest rates, urban investment, real estate, and other key sectors. As a fund primarily investing in Chinese USD bonds, the Dacheng Total Return Bond Fund is managed by an excellent investment team. Core members of Dacheng International’s investment team previously conducted extensive macro and quantitative strategy research at internationally renowned investment banks, managing multiple strategies across countries, markets, industries, and asset classes. Their rich investment research experience has yielded excellent performance, earning industry accolades, including the Overseas Golden Bull Award from China Securities Journal for two consecutive years (2018, 2019). Due to robust credit research capabilities, the fund successfully avoided investing in bonds related to the recent Henan state-owned enterprise default event.

● Chinese USD Bonds Have Relatively Better Quality and Higher Cost-Effectiveness Due to Information Asymmetry

Chinese USD bonds generally have better quality since domestic institutions face significant hurdles issuing bonds offshore, requiring regulatory approval, which acts as a form of pre-screening. Additionally, considerable information asymmetry exists between domestic and international markets. Due to the segmentation of domestic and international markets and differences in rating systems, some high-quality Chinese institutions with good ratings domestically receive lower ratings abroad, often resulting in higher bond yields compared to domestic counterparts. This information asymmetry benefits investors familiar with Chinese institutions, providing offshore Chinese USD bonds with relatively higher cost-effectiveness.

$Da Cheng China Balanced Fund (HK0000524279.MF)$
$Da Cheng China Balanced Fund (HK0000524253.MF)$

As Futu's focus fund for November, the Dacheng China Flexible Allocation Fund is a mixed fund investing in A-shares and domestic bonds. Its bond allocation primarily focuses on high-grade bonds and government bonds. Since its inception, the fund has navigated through bull and bear cycles, consistently delivering strong short-, medium-, and long-term performance. It won the Overseas Golden Bull Award in 2018 and achieved first place in the Bloomberg Offshore Chinese Fund Awards for one-year, three-year, and five-year periods in 2019. The fund adopts a flexible investment strategy, adjusting positions between bonds and stocks based on market conditions, achieving offensive and defensive flexibility in complex and volatile investment environments.

Risk Disclosure

Dah Chieh All-Income Bond Fund

The investment objective of the Dah Chieh All-Income Bond Fund is to provide medium- to long-term stable income and capital appreciation through a diversified portfolio of global debt securities. There is no guarantee that the Fund will achieve its investment objective. Investment involves risks, and the main risks potentially associated with the Fund include investment risk, currency risk, risks related to debt securities, risks of investing in convertible bonds, risks associated with investing in contingent convertible bonds, risks associated with investing in city investment bonds, 'dim sum' bond market risk, emerging market risk, concentration risk, risks related to securities lending and repurchase transactions, hedging/derivative risk, risks related to China, risks related to the RQFII system, China tax risk, risks related to the China interbank bond market, Renminbi currency risk and Renminbi class risk, hedging of Renminbi, Hong Kong dollar, euro, Australian dollar, and New Zealand dollar classes ('hedged share classes') risk, risk of distributions being paid out of/or effectively out of capital, etc. Please refer to the offering documents for further details, including risk factors.

Dah Chieh China Flexible Allocation Fund

The investment objective of the Dah Chieh China Flexible Allocation Fund is to seek long-term growth of capital and income. Investors should carefully read the Fund’s offering documents to obtain further information about the Fund's details and risk factors. Investors should pay particular attention to the risks involved in investing in emerging markets. The Fund may be subject to fixed-income securities risk, risks related to equity securities, risks related to the RQFII mechanism, investment concentration risk, risks related to China, China tax risk, liquidity risk, Renminbi currency and exchange risk, risks related to Stock Connect schemes, risks related to the China interbank bond market, investment risk, dividend risk, etc.

Disclaimer

This BullCircle provides information on Dah Chieh International Asset Management Limited (“Dah Chieh International”) and its services and products. The information contained in this BullCircle, if required to be registered before publication in certain jurisdictions, has not been intended for publication by Dah Chieh International within such jurisdictions. Non-Hong Kong investors are responsible for complying with all applicable laws and regulations within their jurisdiction before accessing the information contained in this BullCircle.

The information provided in this BullCircle is for reference purposes only and does not constitute any investment advice. Past performance may not be indicative of future results. Investment involves risks. Investors may lose all of their invested capital; please read the relevant offering documents carefully, especially regarding the nature of the funds and the risks involved in investing in them. The information contained in this BullCircle does not constitute any offer, invitation, recommendation, or solicitation to purchase any products offered by Dah Chieh International, funds of Dah Chieh International, or as a guideline for any investment advice.

This BullCircle may contain forward-looking statements based on the opinions, expectations, and projections of Dah Chieh International. Dah Chieh International has no obligation to update or revise any forward-looking statements, and actual results may differ materially from those anticipated in the forward-looking statements.

This article is published by Dah Chieh International and has not been reviewed by the SFC. You are advised to proceed with caution. If you have any questions about the information on this website, you should seek independent financial and professional advice. Investors should consult their investment advisors, banks, or other professional advisors. The information contained in this BullCircle does not constitute investment advice or an opinion on the feasibility of any investment or investment service. Prospective investors should seek professional advice before making an investment decision.

The value and income of the Fund units can go up or down. Past performance or any forecast may not represent the future or potential performance of the Fund. Neither Dah Chieh International nor any of its affiliates or designated distributors assumes any responsibility for the investment returns of the Fund, nor makes any warranty or representation. Dah Chieh International endeavors to ensure that the information contained in this document is accurate and reliable but does not guarantee its accuracy or reliability. Dah Chieh International shall not be liable for any loss caused by inaccurate information or omission of information. Without the consent of Dah Chieh International, no part of the data or content of this BullCircle may be copied or distributed.

145K Views