It seemed like a good idea at the time, but now an incentive that helped sell US$668 billion of corporate bonds to Chinese investors is coming back to haunt borrowers.

They’re embedded put options, a feature that lets debt holders demand repayment, typically after interest rates rise. With borrowing costs ticking higher amid Beijing’s squeeze on debt, one company has already defaulted this month after investors requested they be paid back early.

Ratings companies are warning there’s more to come with China accounting for about 69 per cent of all the puttable notes worldwide, according to data compiled by Bloomberg.

“We expect onshore bond defaults to rise this year as liquidity tightening and high funding cost are hurting weak companies’ refinancing,” said Christopher Lee, managing director of corporate ratings at S&P Global Ratings in Hong Kong. ‘Bondholders may be increasingly likely to exercise their put options as credit quality of the issuers deteriorate.”

After leveraging its way out of the global financial crisis, China is cracking down on excessive and speculative borrowing amid concern it poses risks to the financial system. The campaign has driven up costs across the corporate bond market, with yield spread on AA- notes, considered junk in the nation, up 63 basis points from a low reached on October 30, to near the highest since June last year. That’s a challenge for companies engaged in debt refinancing.

Companies to watch out for in the coming months will be developers as they face the highest pressure among all sectors for early redemptions with 870 billion yuan (US$137 billion) of puttable bonds outstanding, Bloomberg-compiled data show.

Investors are increasingly worried about the risk of non-payments and are demanding a higher premium for puttable bonds, according to China Chengxin International Credit Rating Co., which expects the yield gap to further widen as defaults accelerate.

The cracks are already showing, with these companies feeling the heat:

  • Beijing-based Shenwu Environmental Technology cited a capital shortage for failing to repay a 450 million-yuan (US$71 million) privately placed bond that investors exercised an option to sell back to the firm on March 14.
  • Shoemaker Fuguiniao said March 7 it is uncertain if it can make early redemption payments on April 23 for a 800 million yuan note, and is assessing all means to come up with funds.
  • Xinjiang Kingtec Steel faces uncertainty in paying bondholders for a put option coming up May 23 on a 550 million-yuan debenture as the funds required aren’t ready, the steel manufacturer said on March 8.

“If an issuer’s credit profile is deteriorating, investors are more motivated to exercise the put options to get their money back,” said Ivan Chung, head of Greater China credit research at Moody’s Investors Service in Hong Kong. “In such cases, the exercise of put options will aggravate the issuer’s weakening liquidity position and deteriorating credit quality, thereby increase their default risks.”

As holders exercise their put options, issuers are pushed into a corner, having to boost interest payments to try and retain investors or redeem the debt when the options are exercised.

In Shenwu’s case, all investors chose to put the bonds back to the company even after the borrower raised the coupon rate by one percentage point to 9 per cent.

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