China’s domestic bond markets have seen a growing number of defaults in recent years after hitting historic lows as policymakers’ deleveraging campaigns and the government’s supply-side reforms gathered steam.

A slowing economy and the authorities’ greater tolerance for defaults also contributed to the rise.

Surprisingly, this has had a positive impact on investor sentiment and participants view this as another step towards the deepening of fixed income markets.

A recent report by rating agency S&P Global showed that aggregate defaults in 2019 had exceeded 100 billion yuan (US$14.2 billion) and would overtake last year’s record of 111 billion. This would be mainly on account of private-sector defaults, which showed a default rate of 4.1% compared with the 0.5% default rate by the public sector.

The defaults have triggered greater differentiation between borrowers and investors are demanding higher yields from weaker companies as the illusion of a tacit guarantee fades. The spread between AAA-rated companies, the strongest borrowers, and those rated AA, a notch below, has doubled to 300 basis points (bps) from 150 bps in 2017. This is much wider than the 100 bps differential in 2010, according to Fitch Ratings.

“We believe this is a much needed, positive development for the Chinese onshore credit bond market, with greater distinction between good and bad credits, poorly managed companies going out of business and valuations reaching more fair levels. More credit ratings by independent foreign rating agencies should also increase transparency of the onshore credit market,” said Karan Talwar, senior investment specialist EM debt at BNP Paribas Asset Management.

China’s onshore bond market is the second-largest in the world by bonds outstanding, with considerable diversity in both issuers and products. In 2018, it overtook Japan to become the second-largest in the world in terms of bonds outstanding, behind the United States.

High profile defaults in the offshore bond market by Chinese issuers with government connections have investors questioning the implicit guarantee.

On Monday, Hohhot Economic and Technological Development Zone, an entity owned by a local government, had failed to meet a bond repayment deadline.

Tewoo Group, a Chinese state-owned commodities trader and government-owned holding company Peking University Founder Group are both struggling to pay their debts. These two are high profile names known to international investors because they have dollar-denominated bonds outstanding.

“Many investors have not bothered to do their homework because of the widely believed government put. They will now start asking questions and demand more information,” said a Singapore-based fund manager who declined to be named because he was not authorized to speak to the media.

But he said it would not deter the inflows from international investors who are expected to troop into China once the domestic bonds are included in global indexes.

“No one is looking beyond the CGBs and the top-notch state-owned firms,” he said.

Investors in the domestic bond market are voting with their feet – net bond refinancing by the private sector has declined this year as they get squeezed out of the market. Government and quasi-government bond offerings have surged.

Late last month, Beijing brought forward and allowed local governments to tap into their 2020 special bonds quota. This was to support the economy and provide it with a boost after GDP in the July-September quarter fell to 6%, the weakest growth rate since the first quarter of 1992. GDP annual growth rate in China averaged 9.39% from 1989 until 2019.

“The guideline is consistent with our view that the central authorities continue to take steps to urge local governments to put new debt onto their balance sheets, and take into account the need to shore up local borrowing to fund projects that will promote fixed-asset investment targets and GDP growth,” Susan Chu, Senior Director at S&P Global Ratings.

Still, the impact from the defaults in the private sector will have a limited impact in overall foreign investment sentiment.

The Bloomberg Barclays Global Aggregate Bond index inclusion only included Chinese government and policy bank bonds, and not any corporate bonds. Similarly, JPM will only include Chinese government bonds.

“In addition, most of the foreigner interest has either come from Foreign Exchange Reserve managers or asset managers who have increased allocation to government and policy bank bonds, or money markets, as opposed to in risky onshore corporate debt,” said BNP’s Talwar.

“Finally, onshore Chinese credits have generally traded expensive to offshore Chinese credit markets, so valuations are not compelling either,” he said.