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COVID, China Risks Won't Pass For Years, Say Panelists

Investors in Asia corporate credit are bracing for more idiosyncratic and regulatory risks. A prolonged COVID-19 pandemic and China's clampdown on key sectors will raise corporate risks for years to come. This is the sobering assessment by panelists at a recent credit conference hosted by S&P Global Ratings.

S&P Global Ratings predicts that eight of 16 corporate sectors globally will return to pre-pandemic credit metrics by the end of 2021, leaving the "year of the recovery" only halfway there. Further delays would pile on more stress for firms facing record high debt and receding government stimulus. How to manage these risks and identify winners and losers over a multiyear horizon was a key focus of the discussions.

The webcast conference comprised three panels focusing on themes shaping the outlook for Asian corporates. These include opportunities and challenges from surging green bond issuance, rising exposure to inflation and rates shocks, and the likelihood for more defaults across the region.

Participants In Our August 2021 Asia-Pacific Corporate Credit Webcast
Session 1: Resurging Risk In Asia And Beyond
Moderator Industry participants S&P Global Ratings panelists
Christopher Lee, Head of APAC Corporates, S&P Global Ratings Johanna Chua, Head of Asia-Pacific Economics, Citi Jeanne Shoesmith, Senior Director, Global COVID Lead & Chair, Analytical Oversight and Consistency Council
Carolyn Chu, Director of Research, Fixed Income, T. Rowe Price
Session 2: China--Green Bonds, Regulatory Event Risks, And Post-Default Changes
Moderator Industry participants S&P Global Ratings panelists
Charles Chang, Senior Director, Greater China Country Lead, Corporate Ratings, S&P Global Ratings Alan Siow, Portfolio Manager, Ninety One Clifford Kurz, Director, China Technology Lead, Corporate Ratings
Chang Li, Director, China Country Specialist, Corporate Ratings
Session 3: South and Southeast Asia--COVID's Return, Next Defaults, SOEs And ESG
Moderator Industry participants S&P Global Ratings panelists
Anthony Flintoff, Managing Director, Corporate Ratings, South and Southeast Asia, S&P Global Ratings Dhiraj Bajaj, Head of Asia Credit, Lombard Odier Group Xavier Jean, Senior Director, South and Southeast Asia Country Lead, Corporate Ratings
Abhishek Dangra, Senior Director, Sector Lead, Infrastructure Ratings, South and Southeast Asia,
Source: S&P Global Ratings.

Macro View: Will We Ever Return To Normal?

"Asia didn't have as much stimulus as the U.S., which raises the question if we will return to pre-COVID output levels, as a lot of losses cumulated from disruptions and dislocations will drag on productivity growth," said Johanna Chua, head of regional economics from Citi. Ms. Chua noted that some economies may see prolonged drags on growth, and some sectors, such as tourism in Thailand, may never return to pre-COVID growth prospects.

Jeanne Shoesmith shared this perspective. S&P Global Ratings' lead on COVID recovery pointed out that the bulk of the global corporate universe has yet to return to pre-pandemic credit health. Although positive rating actions outnumber negative actions by three times in 2021, they are mainly among the lower-rated entities and are still just a fraction of the downgrades seen in 2020. Ms. Shoesmith expects structurally lower credit ratings, higher levels of debt, and potentially more volatile default rates for many years to come.

Chart 1


For Asia, Xavier Jean, our South and Southeast Asia Country Lead for Corporates, noted that only a quarter of rated sectors in Asia have recovered to pre-COVID levels (see chart 2). Roughly half, including capital goods, real estate, and leisure, will not recover until mid- to late next year. The rest will take well into 2023 and beyond.

"Things have come a very long way since the height of the pandemic," said Mr. Jean. "But we'll probably see more credit events and more defaults throughout the next 12 months."

Chart 2


What Are The Long-Term Risks?

Rising interest rates and cost inflation are key risks that may, increasingly, price into assets, said Carolyn Chu, director of Emerging Market Research at T. Rowe Price. Corporate margins are starting to weaken. She noted that preferences have shifted to investment grade from speculative grade in Asia and other emerging markets. "Frankly, the pickup that you're getting on some high-yield assets does not make sense against the rising default risk and stresses of high-yield issuers."

Ms. Chu thinks this technical tailwind is largely based on the assumption of continued low U.S. rates, which could turn out to be a risky view. "Emerging market central banks are already showing some divergence from the Fed, and taking more hawkish views," she warned.

The legacy of high debt is another key risk. Ms. Shoesmith of S&P Global Ratings noted: "Funding conditions are very supportive, spreads are remarkably tight--lower than pre-pandemic in many cases, which shows the huge appetite for risk to gain yield." Cheap funding is driving the major risk for ratings now, as some companies pile more debt onto stretched capital structures to fund mergers and acquisitions, capital spending, and shareholder-return exercises. Markets are tolerating higher and higher levels of debt as more companies pursue aggressive financial policies.

High debt makes companies more vulnerable to shocks. Ms. Shoesmith noted that in a downside scenario under S&P Global Ratings' latest stress tests--where the dual shocks of interest rates and cost inflation both escalate--default rates could spike to 12%, which is close to the levels during the global financial crisis in 2008. "Investor repricing of risk amid inflation fears is key to watch over the near term," concluded Ms. Shoesmith.

Primary Market: One Growth Sector In The Disappointing Recovery

Charles Chang, S&P Global Ratings' Greater China Country Lead for Corporates, said one sector has shown consistent growth regardless of COVID, rates, price volatility and defaults: green bonds. He noted that 2021 is by far the strongest growth year for green issuance across all sectors in Asia, with investment grade jumping by 50%, speculative grade by 5x, China tripling, and North and South and Southeast Asia (SSEA) each doubling or more.

Asia-Pacific Green Issuance Has Been Booming In 2021

Chart 3a


Chart 3b


Chart 3c


Mr. Chang noted that China real estate and North Asia investment grade have become the two pillars of Asia's green bond market, each accounting for a third or more of all issuance this year. The flurry of new bonds and the lopsided sector weighting create challenges for investors seeking to satisfy mandates that require genuine green credits, the panelists said.

Chart 4


Risks Of The Green Boom To Investors And Issuers

"We care about how green the bond actually is rather than how green it's labeled," said Alan Siow, Portfolio Manager at Ninety One. He added that the "best in class" green bonds are those with a clear tie between the use of proceeds and a certifiable green purpose, where the issuer is truly engaged with the spirit of the rules and has set up a clear framework with measurable goals audited by a third party. Significant improvement in disclosures have made tracking easier in recent years, he added.

Chang Li, S&P Global Ratings' China Country Specialist, said that for China's domestic green bonds, only 50%-70% of proceeds go to green projects, well below the 95% required for global markets. Investors are also challenged by the costly burden of monitoring and regulatory confusion. Different regulators, such as the National Development and Reform Commission and the China Securities Regulatory Commission, have different rules and varying green issuance and other environmental, social and governance (ESG) requirements.

Dhiraj Bajaj, Head of Asia Credit at Lombard Odier said that many companies are still just paying lip service to ESG compliance. "Investors will see through that, and their funding costs will go up," Mr. Bajaj predicted, noting that in the past two years, ESG-compliant bonds in Asia have seen yields move below 4% while noncompliant securities moved to above 7%. He thinks some companies, such as coal miners, could be completely shut out of bond markets over time if they don't take ESG seriously and have no transition plan.

Secondary Market: The Shift From Sector To Idiosyncratic Risks

Turning to the secondary market, the panelists agreed that when COVID-19 first hit, the pain was indiscriminate. All hotels, airlines, casinos, restaurants, and shopping malls were empty regardless of where they operated.

This is no longer the case. Mr. Jean of S&P Global Ratings pointed out it is now harder to generalize risks on a sector basis, as they have become company specific. "One of the key learnings from this crisis is that the damage is more sector specific at the beginning. Then, over a few quarters, individual credit profiles of issuers in the sector start to diverge," said Mr. Jean. "Now it's about idiosyncratic risk. Some palm oil companies were able to refinance, others were not. Some airlines have defaulted, others have not. The bigger and more diversified companies, with stronger balance-sheet management and governance, will do better than small firms with less access to funding or financial buffers."

Sorting Out The Winners And Losers

Mr. Bajaj of Lombard Odier believes the lines will grow shaper between "the haves and have-nots," where entrenched players with better management systems and better access to capital will be the market consolidators. India is one market where he particularly expects such divergence. "Many companies have been hit, but we think it's transient. If you take a five- to 10-year view, these survivor companies will gain more market share, they will come out stronger."

Working capital can flag the more vulnerable firms. "Coming out of COVID, working capital is going to be more important than during COVID, because when economic activity picks up, companies will want to add capacity, will need to increase inventory, and may extend receivable days from their customers to further stimulate demand." Mr. Jean noted this will require a lot of working capital and short-term funding needs, which will most likely result in more debt, and could plant the seeds for the next wave of defaults three or five years from now.

Chart 5


Are Regulatory Events Making China Risks Unmanageable?

China offers prominent examples how regulatory events drove idiosyncratic risk that caught investors off guard across a number of sectors in the past few months.

Why and why now? This is a question Mr. Chang, as moderator, put to the panelists. These actions have stoked volatility in China's bond markets, which were already under pressure from rising defaults and tightening financing conditions. Further complicating the situation are the idiosyncratic events at the country's largest bad debt asset manager, China Huarong, and property developer, China Evergrande, Mr. Chang noted.

"It's important to understand the framework the Chinese government is working with," said Clifford Kurz, S&P Global Ratings' China technology lead analyst, who cited three key objectives: growth and innovation; social stability and fairness; security and control.

Chart 6


Historically, growth and innovation have been the priorities, said Mr. Kurz. Today, China has some of the world's largest and most innovative tech companies, and its economy is one of the world's most digitalized. Some internet companies may have abused their market power and created apparent wealth gaps that undermined the objective of fair competition and social stability. At the same time, heightened geopolitical tension is raising concerns on national security over the collection of personal data.

"This is more of a case of 'regulations with Chinese characteristics'," Mr. Siow of Ninety One added, noting that this theme is playing out globally. "Wherever there is disruption or disintermediation, there's a resetting of the rules." China's response is different because its lens is different and its perspective is different, said Mr. Siow. "When investing in other markets, you are a guest and are playing by someone else's rules. As they change the way they think, investors have to be cognizant and vigilant, that's why there is a premium on these markets."

Mr. Siow thinks the risks are decidedly more prominent for equity investors. If companies can't raise capital or acquire companies to grow, their growth and profitability profiles can deflate equity valuations. For a debt investor, "mild reduction in margins to accommodate what the regulators want does not change their credit story--high quality [investment grade] remains high quality investment grade."

How to Prepare For Defaults to Come

Most of our panelists think default rates are set to rise in Asia. This is partly a structural issue, because government support to state-dominated industries in the region have suppressed defaults in the past. However, "to mature and develop, we need some proper risk pricing," said Ms. Chu of T Rowe Price. "Default rates are artificially low and the only way to go is up."

Mr. Siow shared this view. "We expect and we need to see more defaults. Without defaults the market is not fully functioning. We need carrot and stick. The carrot being returns and lower yields and the stick being the specter of defaults to enforce discipline and to provide a reward for discerning investors," he said.

Fiscal pressure wrought by the pandemic will force governments to be more selective with the support they will offer to state-owned companies, as has been seen with local governments in China.

In South and Southeast Asia, default risks in the infrastructure sector were surprisingly low during COVID. Abhishek Dangra, S&P Global Ratings' Sector Lead for SSEA Infrastructure, notes that India's government rolled out a liquidity scheme to the renewables sector, and that markets even stayed open for the hard-hit airlines sector at the height of travel restrictions.

Mr. Jean surmises that default rates stayed relatively low due to strong funding conditions preceding the COVID crisis, allowing issuers to issue long-dated bonds and extend their debt maturity profile. Rated issuers in Southeast Asia raised five-year duration debt during 2017-2019. However, maturity walls will start looking higher over the next several years. Indonesian issuers, for example, have about US$15 billion of maturing debt through 2024.

Markets tend to be optimistic and disregard risks when funding is available--which is why investors should start focusing less on liquidity and more on solvency. Mr. Bajaj believes this should involve more than just analyzing "hard" data such sustainable capital and asset structures. It also includes "soft" signs such as management and governance. Meeting debt obligations can sometimes come down not just to ability--but to willingness.

Related Research

This report does not constitute a rating action.

Greater China Country Lead:Charles Chang, Hong Kong (852) 2533-3543;
Secondary Contacts:Jeanne L Shoesmith, CFA, Chicago + 1 (312) 233 7026;
Xavier Jean, Singapore + 65 6239 6346;
Clifford Kurz, Hong Kong + 852 2533 3534;
Abhishek Dangra, FRM, Singapore + 65 6216 1121;
Chang Li, Beijing + 86 10 6569 2705;

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