Credit risk measures, as a guidance for investors, are vital in any financial market. A lack of, or bias in, such measures hampers market development. The large and increasing Chinese bond market contrasts with the low diversification in credit risk as measured by ratings as a standard guidepost for investors. Currently, China de facto has only three rating categories. However, since the first default in 2014, the country has witnessed a wave of credit events. The ever growing default incidents that peaked in 2019 have ignited investors’ concerns about credit risks. However, from our perspective, these temporary market disruptions are inevitable pains that China has to go through towards a more market-oriented financial market.
The skewed distribution of credit ratings1…
A key characteristic of bonds is their credit risk as reflected in ratings. The distribution of Chinese ratings is well-known to be skewed to the upside (Kennedy 2008, Poon 2007, Standard Chartered 2017). Despite the large market size (about 2,000 corporate issuers) according to global standards, over 95% of the outstanding amount of non-financial credit bonds are covered by only three rating categories (Figure 1, Panel a). At the end of May 2019, 56% of outstanding corporate bonds in China enjoyed a AAA rating, versus about 6% in the US corporate bond market; 22% of Chinese corporate bonds are rated AA+, another 18% are AA rated, and only 2% are rated as AA- and below (and therefore as non-investment grade). Of the outstanding amount of corporate bonds, 1% are not rated. The high share of AAA-rated corporate bonds in value terms is partly explained by the large amounts of bond issuance of just a few issuers who are mostly linked to government. Of the top ten issuers,2 only one is privately owned (a real estate corporate), while the others are all central state-owned enterprises. Consequently, China currently has essentially no high-yield or speculative grade bond market.
Figure 1 Corporate issuer by outstanding and number of issuers
a) Non-financial corporate issuer ratings by outstanding bond balance, 31 May 2019
b) Non-financial corporate issuer ratings by number of issuers, 31 May 2019
Source: Wind Database.
Notes: We count the number of issuers for each rating class using all corporate bonds available on 2018/12/31. We exclude all asset-backed securities (资产支持证券) in the corporate bond category. Since the ‘issuer’ performs more of the role of an ‘underwriter’ of these asset-backed securities, the issuer rating does not represent accurately the creditworthiness of the security.
… as a hindrance to further bond market development
This skewed distribution has positive and negative aspects. On the one hand, the low credit risk differentiation is generally seen as a hindrance to the development of the bond market. For domestic investors, the absence of more granular credit risk opportunities and the lack of a speculative, high-yield market might lower the attractiveness of the bond market, particularly relative to the stock market. For international investors, the low guidance offered by the current rating distribution is often given as one reason why they currently take up only a small part (around 3%) of the investor base in the Chinese bond market, despite a steady loosening of investment restrictions. Doubts regarding the accuracy of the rating process are also regularly expressed. Among others Deng and Qiao (2019) identify and summarise four factors that consistently bias credit rating process to the upside: low competition among rating agencies, rating shopping, systematically more upgrades than downgrades, and rating-contingent regulations. Comparing ratings from domestic versus global agencies, Jiang and Packer (2017) find the latter to be six to seven notches lower on average. On the other hand, the implicit guarantees entailed in the credit assessments of a good part of corporate issuers with links to government may partly justify a higher rating.
A market-based credit measure – credit spreads
Credit ratings should reflect bonds’ default probabilities. There is a wide perception among bond investors that ratings based on an ‘implicit government guarantee’ are not that accurate in China. Consequently, there is a strong interest in alternative credit risk measures which are market based, such as credit spreads.
Figure 2 plots the credit spreads of enterprise bonds, defined as the bond yield minus the matched China Development Bank yield,3 across all ratings since 2013. Typically, both bond-level and issuer-level ratings are downgraded before the default event, following negative public announcements by firms, which drives the rise of credit spreads. The credit spreads of lower rated enterprise bonds (A and BBB+) experienced a clear upward trend since early 2014, dipped a bit in 2017, but soared again in early 2018.
The evolution of the credit spreads and their dispersions in Figure 2 reflects not only perceived default probabilities across various rating classes, but also the credit conditions of the bond market as a whole. The continuing tightening credit and policy environment since 2017 contributed to the rising credit bonds spreads. The major driver, however, is the recent burst of bond defaults which has been a game changer for how implicit guarantees are perceived, and has caused jitters among some major investors.
Figure 2 Credit spreads of enterprise bonds in China across ratings (%)
Source: Wind Database Bond Yield Analysis.
Notes: The figure depicts the one-year credit spreads of bonds with different ratings (AAA, AA, A, BBB+) from the beginning of 2012 to 2018. The credit spread is defined as the bond yield minus the corresponding China Development Bank spot yield for each rating.
Gradually breaking the prior of the implicit guarantee
The main reason for the high credit ratings and low dispersion of credit spreads is the very short and limited history of defaults in China. The first onshore public bond default occurred only in 2014. The unprecedented bond default event of ‘11 Chaori Bond’ on 5 March, 2014 marked the elimination of the implicit government guarantee, opening a new era for the Chinese bond market. The issuer, Shanghai Chaori Technologies Inc., failed to pay its interest in full in the exchange market, constituting the first-ever default in the Chinese bond market. In a recent paper (Amstad and He 2019a), we review several landmark default cases in the Chinese bond market, together with a discussion of recent progress in bankruptcy rulings in China.
The amount of defaults in the Chinese bond market was only 1.26 billion RMB in 2014, reached a first peak of 30.1 billion RMB in 2016, before falling to 27.7 billion RMB in 2017. The amount of defaults jumped to a new high of 128 billion RMB in 2018. The current year seems prone to set a new record, since as of May 2019 defaults had reached 56 billion RMB, compared with 19.6 billion RMB in May 2018 (Figure 3, Panel a).
This surge in corporate defaults was triggered by challenging refinancing conditions and increasing redemptions due to tightened regulation which started at the end of 2017. What’s more, in late 2017 Beijing tightened regulations on wealth management plans. Together with the government-led deleveraging campaign, this further curbed the inflow of funds towards corporate bonds, especially towards lower rated ones which were on the edge of defaulting. This worsened their default probability and, in turn, made institutional investors even more cautious in purchasing newly issued bonds of these firms. This type of negative rollover spiral due to market liquidity dry-up is responsible for the explosion of bond defaults in early 2018.5
However, since the first default in 2014 and until the end of 2018, defaults represented only 0.2% of the overall outstanding amount, suggesting a rather small default probability relative to the global counterpart. Up until 31 December 2018, there were 263 defaulted bonds, involving 111 issuers in total. Figure 3 in Panel B plots the distribution of these default events since 2014, as a fraction of the entire corporate bond market in China, based on the Wind database. A total of 94 private firms defaulted, taking up a larger percentage of the issuers’ sunk-in defaults. For state-owned firms, there are 11 defaulting enterprises owned by local governments, while only six are central state-owned enterprises. Industry-wise, before 2017, defaults were concentred in over-capacity ‘old-economy’ sectors, such as coal, steel, and commodity-related industries. However, in 2018, the fraction of ‘new-economy’ defaulting firms increased.
Finally, the percentage of defaulted bonds relative to the total amount remains quite low, standing at 0.6% in its peak year, 2018. In contrast, the global counterpart during 2008-2017 is 1.8% according to a recent report by Moody’s.5
Figure 3 Number and amount of defaults by year
a) Defaulted bonds: Number (left axis) and amount (billions RMB, right axis)
b) Defaulted bonds: Number (left axis) and amount (right axis) as a percentage of total corporate bonds
Source: Wind Database Credit Bond Research (Defaulted Bond Summary Table and Issuers First Default Table).
Notes: We report the number and the amount of defaulted bonds, both in amounts (Panel A) and percentage (Panel B, relative to all corporate bonds). We count the principal value of defaulted bonds only (excluding interest). We also correct for obvious data errors in the Wind dataset of defaulted bonds. For instance, we only keep one record for duplicates of defaulted dual-listed bonds, except Jiangquan and Hongchang Gas (these two issuers do have two separate default events, one for principal default and the other for interest default). Finally, the private firm category includes all firms in our sample that are not state-owned enterprises. All numbers are as of the end of each year.
Chinese bond defaults – tiny, yet painful and needed for further development
Despite the relatively tiny amount of defaulted bonds compared with the entire market, the jitters prompted by the default shocks have influenced not only the bond market, but also the entire Chinese financial system and the macroeconomy. Investors’ priors of ‘implicit government guarantee’ were gradually broken. Financial institutions ceased to take it for granted that corporate bonds are absolutely safe and began to put more and more emphasis on the credit risks embodied by firms.
Markets need guidance through credit measures. Those are only possible with a history and amount of defaults. Chinese bond defaults – as long as they remain low relative to global standards – are a step in the long way of market development.
Amstad, M and Z He (2019a), “The Chinese bond market and interbank market”, NBER working paper 25549.
Amstad, M and Z He (2019b), “Underestimated role of banks in China’s bond market”, VoxChina.org, July 2019.
Deng, K and G Qiao (2019), “Double A Failure”, working paper.
Jiang, X and F Packer (2017), “Credit ratings of domestic and global agencies: What drives the differences in China and how are they priced?”, BIS working paper.
Kennedy, S (2008), “China’s emerging credit rating industry: The official foundations of private authority”, The China Quarterly 193: 65-83.
Moody’s (2018), Annual default study: Corporate default and recovery rates, 1920-2017, Research report.
Poon, W and K C Chan (2008), “An empirical examination of the informational content of credit ratings in China”, Journal of Business Research 61: 790-797.
Standard Chartered (2017), China’s credit rating framework, Global research report.
 As government bonds are always AAA rated, this column focuses on ‘credit bonds’, including financial and corporate bonds.
 China National Petroleum Corporation (中石油), State Grid Corporation of China (国家电网), Central Huijin Investment (中央汇金投资), State Power Investment Corporation (国家电力投资公司), Tianjin Infrastructure Construction & Investment Group (天津城市基础设施建设投资集团), China Railway Corp (中国铁路总公司), Datong Coal Mine Group (大同煤矿集团), China Southern Power Grid (中国南方电网), Shougang Group (首钢集团), Dalian Wanda Commercial (大连万达).
 In the Chinese bond market, the risk-free benchmark is given by the yield of bonds issued by the China Development Bank, not by that of treasury bonds. The former has the same tax treatment as other fixed-income securities, and better secondary market liquidity.
 The companies which defaulted in 2018 have much stronger balance sheets than those which defaulted in 2016-17, in terms of simple financial ratios like book leverage and interest coverage (China International Trust Investment Corporation Securities).
 This estimation is derived from Moody’s (2018), which covers the credit histories of more than 25,000 corporate issuers that had long-term rated bonds between 1920 and 2017.