Puttable Bonds of China-A new threat to Financial System!

Before starting with the detailed analysis of Puttable Bonds, we must learn what does Puttable Bonds actually means?

A put bond is a bond with an embedded put option, giving bondholders the right, but not the obligation, to demand early repayment of the principal from the issuer or a third party acting as an agent for the issuer.

Now the question is why do companies issue Puttable Bonds?

The issuer can lower their borrowing costs. Investors are willing to pay a bit more for bonds with an embedded put option because it provides substantial flexibility to the investor vis-à-vis redeeming the bond. Investors can lower their reinvestment risk by investing in such bonds.

Why does Investors Invest in Puttable Bonds?

  1. Price of a puttable bond is always higher than the price of a straight bond because the put option adds value to an investor;
  2. Yield on a puttable bond is lower than the yield on a straight bond.

So in nutshell the Capital Gains and Tax rate on Capital Gain helps investors to take extra premium on such Bonds.

Coming on to Chinese Market

The share of outstanding corporate bonds relating to private sector with put options in China is much higher than in the rest of the global markets. Most of the participants are Chinese Real Estate Companies  and big Infrastructure companies. Less than 5% of corporate bonds globally are puttable, in contrast to 27.5% in China (As per Fitch report). However, put options are less common among SOE bonds. Only 22.8% of outstanding bonds issued by SOEs were embedded with a put option, while 56.6% of non-SOE bonds by value were puttable (Estimates of 2019). Almost all puttable corporate bonds in China are bundled with coupon step-ups.. There are usually multiple put exercisable dates coinciding with the coupon step-up dates. Bonds with a put option exercisable within 12 months but with an original contracted maturity date beyond 12 months are not recognised as short-term debt under Chinese accounting standards.

Note on Onshore Chinese Debt Market

Chinese corporates’ net onshore bond issuance – the gross issuance amount minus repayment – surged to CNY1.3 trillion ($193.45 Billion)  in 1H21, from CNY0.2 trillion($29.76 Billion) in 2H20, although still well below the record high of CNY3.0 trillion ($446 Billion)  in 1H20. Local government financing vehicles (LGFV) contributed 83.2% of the net issuance in 1H21. Non-LGFV SOEs’ net issuance rebounded to CNY277.7 billion ($41.32 Billion) in 1H21 from close to negative CNY100 billion as maturities exceeded issuance in 2H20, while the retreat in privately owned enterprises’ (POE) net issuance narrowed to CNY64.5 billion from CNY212.4 billion. The amount of maturing and puttable bonds is likely to rise to CNY5.0 trillion–5.4 trillion ($744 Billion-$803.57 Billion) in 2H21 from CNY4.9 trillion ($729 Billion) in the Previous year first half, depending on the size of short-term instruments such as commercial papers that will be rolled over. However, at present scenario due large number of outstanding repayments and mass defaults, creditors are not in a position to trust Chinese Corporate or Banking System. Further pressure will be created to get redeemed with what creditors are getting from China. So will it put pressure on Companies having Puttable Bonds and calling for early repayment?

It seemed like a good idea at the time, but now an incentive that helped sell $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 percent 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 direct

Conclusion

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. If an issuer’s credit profile is deteriorating, investors are more motivated to exercise the put options to get their money back. What will happen when mass scale redemption is called after seeing the failure of Real Estate in China? Will they be able to raise loan and repay the existing debt? What will happen to this one Trillion dollar market?

By CA Nishant Maheshwari, Vishal Vora

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