China downgrade does little to sour bonds

Offshore bonds largely defy a one-notch Moody's downgrade of the sovereign, with secondary prices moving out only by a few basis points — and at least one issuer braving the primary market.

When a rating agency downgrades a major economy, it is supposed to be big news. But after Moody’s cut its rating on China from Aa3 to A1 on Tuesday, debt investors largely shrugged.

Chinese credit default swaps moved only a few basis points, new issues were not much worse, and a few hours after the downgrade, China National Chemical Corp started taking orders for a new dollar bond. Why did the news not have a bigger impact?

In part, it is because Moody’s has long flirted with downgrading the country. The rating agency put China on negative rating outlook last March, and has been mulling a decision ever since. That made the timing – rather than the decision — the biggest shock to investors.

Another reason is that the rating action removes a source of uncertainty for investors. Moody’s has now said China’s rating is stable, giving fund managers reassurance the rating agency has no plans to change it again in the near future; The same cannot be said for S&P Global Ratings, which has China’s AA- ratings on a negative credit watch.

But there are other reasons Chinese dollar bonds proved resilient in the face of the news. One is that offshore Chinese investors are such a large source of demand for many dollar deals in the market.

Chinese high-net-worth investors are famously loyal to home-grown champions. The country’s state-owned banks and corporations also tend to cross-hold plenty of debt. Neither appeared to budge after Moody’s announcement.

The market has been further helped by a weaker pipeline than many investors expected, said Arthur Lau, head of Asia fixed income at PineBridge Investments in a statement following the move. This includes supply from Chinese local government financing vehicles (LGFVs), a major supply of dollar bond supply last year.

“High yield bonds and LGFVs supply will be lower than initially expected, thus providing some technical support to [these] sectors,” he said. “Also, we do not see significant offshore Chinese funds going back to onshore. As such, we do not think the yield-chasing mentality will change in near term. It is more attractive for investors who are able to buy on the dip for now, as expected supply from non-China sectors and lower credit quality Chinese names is low."

Where trouble could lie ahead is for state-owned companies and LGFVs. These issuers will see their own ratings downgrades as Moody’s works through the ramifications of its sovereigns downgrade. But bankers said even this raft of downgrades — most of which are likely to also be single-notch — would only fuel appetite for more bond-buying.

“There will potentially be some corporate downgrades to follow,” said a debt capital markets head in Hong Kong. “I hear a lot of people asking about that. But there could be some bottom-fishing. People want to buy on the dip.”

It is also far from certaint that the dollar bond market is in the clear just yet. Several analysts told investors that widening spreads for at least some offshore bonds were likely to result from the move.

“We do expect a higher funding cost in the offshore market, especially for higher leveraged corporates,” wrote Alicia Garcia Herrero, chief economist for Asia Pacific at Natixis. “This is because Moody’s key reasoning for the sovereign downgrade is indeed the rapid accumulation of debt.”

ANZ analysts also told investors to expect a boost in offshore funding costs for Chinese issuers.

“The downgrade will likely lift the cost of financing of Chinese issuers, especially in the offshore market,” according to ANZ analysts Khoon Goh, David Qu & Raymond Yeung. “They will likely turn on onshore financing platforms, including banks, shadow banks and onshore bond markets as these channels do pay less attention to rating actions of international agencies”

Moody's said it was downgrading the country amid fears that China's financial position would "erode somewhat over the coming years". In particular, it pointed to rising leverage and the increasing chance that the Chinese governments focus on growth would lead it to keep filling the gap with fiscal stimulus, leading a rise in government debt.

China's Ministry of Finance responded to the move on Wednesday afternoon, saying the rating agency underestimated its ability to enact supply-side reforms and boost demands, and predicting no major change in government debt in the next four years.

China's five year CDS rate was trading at around 79bp by Wednesday's close, less than 2bp wider on the day. The reaction in the stock market wasequally placid. The Shanghai Composite Index and its Shenzhen counterpart both closed the day slightly up, while the CSI 300 ended the day flat.

The two new Chinese bonds that started trading on Wednesday widened, but not by much. A $500 million five-year bond from Beijing Gas was around 6bp wider, according to market, and China Construction Bank's $1.2 billion three-year floater was around 2bp wider.

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