Tuesday, 25 June 2019

Red alert

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  • Soldiers of the People’s Liberation Army’s guard of honour hold flags in front of Beijing’s Tiananmen Square during the official welcoming ceremony for Serbian President Tomislav Nikolic outside the Great Hall of the People in Beijing.

Investors are starting to pay greater attention to individual credit quality among Chinese SOEs as the pressure for reform dispels earlier expectations of unconditional state support.

China’s state-owned enterprises will be facing more scrutiny from credit investors in the international bond markets as buyers challenge the idea that these firms enjoy blanket support from the PRC government.

State support for certain SOEs is likely to diminish in the future, a concern that investors have been taking into account in their credit-selection process in recent years, particularly as China deleverages its economy by improving efficiency among debt-laden public firms.

The gap between the returns on assets of SOEs and private enterprises is currently the widest since the late 1990s, while the banking sector’s total bad loans stood at Rmb1.27trn (US$195.58bn) at the end of 2015, according to the China Banking Regulatory Commission.

These numbers substantiate concerns that mounting public debt could become a systemic risk to the country’s financial system.

Reflecting these views, there is expected to be a greater dispersion in the yields of Chinese SOEs’ debt instruments on the secondary market because investors take a closer look at individual credits and question the extent of state guarantees, while others expect the scope of these guarantees to change in the future.

Central SOEs, such as CNOOC and Sinopec, have witnessed a compression of yields, largely due to views that their systemic importance will ensure public support in times of stress. CNOOC’s 2025s are trading at around 3.86%, down from the 4% area at the end of last year, according to Thomson Reuters data.

Although yields on the bonds of more remote SOEs have not significantly uncoupled from the broader market so far, the risk of a reduction in public ownership, particularly of local SOEs, could affect their secondary levels in the future.

A couple of defaults have added to the unease. Baoding Tianwei Group, a manufacturer of power equipment, became the first SOE to default on its onshore debt last April, when it missed an interest payment on Rmb1.5bn 5-year notes due 2016. Then, in October, Sinosteel defaulted on Rmb2bn October 2017s bonds, citing liquidity problems, and has delayed interest payments five times since.

Baoding’s 2016s, which traded above 90 cents to the dollar until the beginning of 2014, tumbled to a 28.930 bid, according to Thomson Reuters data. Sinosteel’s 2017s have fallen to the 75 level since November.

SOE reform

The first Sinosteel payment delay came just one month after China promised to create “stronger, better and larger” SOEs through a far-reaching five-year reform programme. Among the planned measures are increased supervision, mergers between SOEs, the introduction of “mixed ownership” and the separate categorisation of commercial and public welfare-related operations.

The programme could have a material impact on credit spreads for certain non-strategic SOEs, particularly if they undergo restructurings or mergers.

One Chinese investor based in Hong Kong said he had been adjusting his portfolio since last year to increase holdings of higher-rated and more systemically important SOEs, and cutting exposure to less central ones due to concerns that the latter could widen in secondary trading.

“Investors can’t expect that SOEs will always be safe from a default,” said a Chinese debt capital markets banker. “A proper default could very well be a new reality, and investors are going to be more aware of this when they invest in primary Chinese SOE deals.”

In such an environment, demand has soared for SOEs viewed as systemically important to the central government. For example, spreads of companies like CNOOC, CNPC and Sinopec, the country’s oil-and-gas exploration giants, are trading tighter than some of their US counterparts.

These companies have also performed better than other SOEs during the global market volatility which began in December, helping investors hedge themselves from the broader weakness in the absence of a proper CDS market in Asia.

Although their bonds widened, the losses were measured relative to the broader markets, even as US crude oil prices dipped to their lowest levels since 2003.

Recent rating actions also underlined the value of state support. Moody’s lowered CNOOC’s baseline credit assessment to A3 from A2 last month on a lower outlook for oil prices, but it also affirmed its Aa3 issuer rating on the view that the company was strategically important to China, providing a backstop to a rating downgrade.

This type of protection cannot be expected for other SOEs, especially those considered less strategic, or those likely to be subject to M&A.

“We see room for SOEs in competitive industries to be downgraded. In addition, local government SOEs have a much higher downgrade risk than do central government SOEs because of higher risk of reduction in ownership or even possible privatisation,” Morgan Stanley credit strategist Kelvin Pang wrote in a report last November.

Pang recommends investors buy SOEs that are strategically important, but have a low percentage of sovereign support priced in. According to the report, 11 bonds meet these criteria, including those of Sinopec, CNOOC, Beijing Enterprises, Zhejiang Energy, Anhui Transport, Baosteel Financing, Yancoal International, China Resources and China Merchants Finance.

The bank bases its calculation of sovereign support on comparisons between an SOE’s spread and the spreads for Double A rated corporations (viewed as a proxy for China’s Double A sovereign rating) and lower-rated ones. The closer the SOE’s spread is to Double A levels, the higher is the percentage of sovereign support priced in. Overall, Morgan Stanley estimates the percentage of sovereign support ranges from 74% to as low as 0%.

In contrast, it sugests investors avoid those which have a higher sovereign support priced in and are operating in less strategic sectors.

The investment bank also says it prefers central SOEs over local government ones due to the higher probability that the latter are exposed to a higher risk of ownership reduction or privatisation.

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