JK Capital: A missed payment in Chongqing raises volatility in the LGFV sector

JK Capital: A missed payment in Chongqing raises volatility in the LGFV sector

18 maart 2021

China
China 2.jpg

By Marcus Weston, CFA, Fixed Income Senior Portfolio Manager, JK Capital Management Ltd., a La Française group-member company

Recently, Asian USD bonds saw a rare event in fixed income markets: The default of an investment grade rated issuer. Chongqing Energy Investment Group (CHQENE), whose USD bonds are rated BBB by Fitch, announced it was late in payment on onshore CNY commercial bills. As a Local Government Financing Vehicle (LGFV) 100% owned by the Chongqing city government, this default exacerbates market speculation that Chinese state-owned entities are seeing reduced support from their government backed shareholders. Unsurprisingly the CHQENE 2022 USD bond price fell sharply after the news while simultaneously creating an increase in volatility across certain segments of the Chinese LGFV and SOE sectors, as market participants try to interpret the evolving policy landscape. It should be noted however that the LGFV sector as a whole remains critical to China’s overall funding landscape particularly in local markets and we believe local government and state-owned entities will remain well supported by government policy.

In the specific case of the CHQENE it appears the default has been triggered by an isolated dispute between the company and its government parent regarding its energy assets. Earlier this year it was announced the company was being forced to close its Chongqing based coal mines this year as part of the government supply side reforms. Although accounting for only 11% of the company’s assets, this raised uncertainty regarding employee compensation, asset coverage and caused some of its coal-based creditors to demand improved securitisation of their loans. Although CHQENE which, as an LGFV, runs tight balance sheet liquidity has typically enjoyed municipal government support to ensure timely payment of obligations, or at the very least promote refinancing support by local banks, clearly this dispute has created near term uncertainty for the company as it led to the missed payment. At this stage it is not inconceivable that the default becomes resolved in the coming weeks. Chongqing is a financially strong local government, and a company representative has reportedly signaled the issuer will continue to service USD bond coupons until the issue is remedied. However, the often followed playbook of default first and resolve later does not help support market sentiment on the sector in the near term.

This, however, is not a new phenomenon. Since the deleveraging campaign of 2018, Chinese authorities have been regularly sending signals to the market that investors should not assume government backed entities would always receive rapid support at times of stress. Trying to install moral hazard into the local currency bond market, the Chinese government has already allowed some CNY bonds issued by State Owned Enterprises to fail in recent years and we believe this is a continuation of that policy.

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