China’s Credit Market Is Moving Into Fresh Phase of Distress

One by one, the pillars of strength in China's property bond market are crumbling.

The selloff that began with China Evergrande Group and decimated nearly all of the country's weaker developers is now threatening giants like China Vanke Co. that until this week seemed largely insulated from the debt crisis sweeping the industry.

It's the latest phase in a cycle of credit turmoil that threatens to spread beyond China's debt-laden property sector as President Xi Jinping's strict Covid Zero policy hammers the world's second-largest economy.

In China’s $870 billion dollar bond market, stress returned to its highest level in June, Bloomberg’s China Credit Tracker shows. Even in the more resilient local market where official defaults have been rare this year, cash-strapped borrowers have imposed countless repayment delays on investors.

The pain is only just beginning, according to Charlene Chu, a former Fitch Ratings analyst known for her warnings about China’s debt risks. “We’ve got a property sector that is almost dead and used to employ huge numbers of people and a lot of downstream industries,” Chu said. “All of that is getting impacted by this property slowdown, and that’s why I think we’re still early in the game here.”

Vanke and Longfor Group Holdings Ltd., the nation’s second and 10th-largest builders by sales respectively, have seen an unprecedented selloff in their dollar bonds this week as investors reevaluate the affect of the crisis on even larger, investment-grade borrowers. While Vanke’s bonds due 2027 still trade at levels well above those of Evergrande, they slumped to a record low of 81.6 cents on the dollar Tuesday.

One of the latest additions to the list of defaulters in China’s offshore debt market is Shimao Group Holdings Ltd., a builder of luxury homes and previously considered a healthier borrower, after it failed to repay $1.4 billion of notes. Meantime, Greenland Holding Group Co., a developer backed by Shanghai government entities, was recently cut briefly to selective default by S&P Global Ratings following a dollar bond maturity extension.

Another watershed moment was an unprecedented dollar bond rout suffered by Club Med owner Fosun International Ltd. last month, when investors expressed worries about contagion risks from the conglomerate’s exposure to real estate. The selloff later expanded to several Chinese industrial firms.

Dive into the methodology behind Bloomberg’s China Credit Tracker

After nearly two years of remarkable resilience, there are signs that investors in China’s $12 trillion local credit market are also beginning to worry.

On the surface, the divergence in stress levels between the country’s offshore and onshore debt markets continues to widen: Defaults on overseas bonds have reached more than $26 billion this year, making up a record 85% of all payment failures; in contrast, missed payments on local bonds have fallen 75%.

However, the onshore calm is mostly the result of borrowers’ ability to force debt reprieves such as repayment delays and debt swaps on creditors who face a less efficient legal system to protect their interests. Many local bondholders find themselves trapped in a cycle of seemingly endless maturity extensions with little room to negotiate, partly as authorities encourage such compromises so as to preserve social and economic stability.

But as economic pressure mounts and strict Covid lockdowns inflict widening damage, some of them are starting to lose patience. In the latest example, China Evergrande Group suffered its first rejection from local creditors to further extend a bond payment, a development that may result in a landmark onshore default and encourage investors to take a tougher stance.

The new phase that China’s credit market is moving into also comes with a changing landscape, with record defaults by developers leading to a rapidly shrinking universe of junk debt. That has dramatically reshaped the composition of global investors’ Asian debt portfolios.

Chinese issuers now make up about a third of Bloomberg’s index of Asia high-yield dollar bonds, down from 56% two years ago.

“There is a lack of new buyers in the China property high-yield space. Fund flow is really poor,” said Carl Wong, head of fixed income at Avenue Asset Management Ltd. “Traditionally, distressed funds will step in at these levels, yet there are too many distressed names at this stage, and many distressed investors are still stuck with companies that defaulted earlier.”

New chapter or not, there are still old problems for investors to keep grappling with, especially the slow progress on restructuring at troubled Chinese firms. In a country where bankruptcies and debt workouts remain relatively new, Evergrande’s debt-revamp plan due in late July will likely become a benchmark for recovery rates on other developers’ delinquent debt.