China default angst flares after case with junk bond

Concern is acute as firms have turned to perpetuals to reduce debt on paper

Arare event in a corner of China’s credit market is fuelling concern that more defaults are looming, adding to strains sparked by the government’s crackdown on leverage.

A timber company in the country’s northeast decided this week not to pay off perpetual bonds despite having an option to do so. That was a first for a junk-rated issuer of such securities in China. Firms that raise money with perpetuals never have to pay off the principal, in theory. But in practice, the bonds usually have coupon rates that increase at set dates along with options letting issuers repay the securities to avoid the escalating interest charges.

Companies wouldn’t stomach surging debt servicing costs, the thinking goes, unless they lack the firepower to just retire the whole obligation. And if their finances have deteriorated that much, they may at some point delay interest payments. The concern is acute in China, where firms have turned to perpetuals to reduce debt on paper given that the securities can be listed as equity on balance sheets.

“If a perpetual bond issuer with high credit risks doesn’t repurchase bonds and if bondholders can’t sell the bonds to anyone else, it’s possible that they may have to sit there and watch valuations decrease until the day of default,” said Wang Ying, a director at Fitch Ratings.