A debt balloon with nowhere to go

Chinese skyscrapers apparently aren’t scaring bond investors, but they probably should.

Debt buyers have brushed off concerns about China’s overvalued real estate and slowing growth this year. They have been snapping up speculative-grade bonds of Chinese companies, even those sold in the U.S., where the appetite for risk is waning in general.

Consider, for example, a $41.5 billion pool of dollar-denominated bonds sold in large part by deeply indebted Chinese property companies. The debt has gained 9.2 percent this year, which is equal to $3.8 billion of market gains, according to Bank of America Merrill Lynch index data.

These hefty returns are pretty amazing when juxtaposed with losses on U.S. high-yield bonds, which have suffered amid plunging commodity prices and waning economic momentum, especially in China.

Frederic Neumann, HSBC’s co-head of Asian economics research, put it more bluntly. “In many ways, the market is divorced from reality,” he said Monday at a conference in New York. While local-currency Chinese debt may hold its value, “the real problem will come in U.S. dollar China corporates.”

Chinese debt markets have benefited from tumult in the nation’s equities, which has pushed local investors into the safety of bonds. A lot of this money is sticky, with institutions wanting to keep their money close to home. But some of these investors have made their way to the U.S., where they’re buying up bonds of Chinese companies. That’s propping up this slice of the dollar-denominated market at an unlikely time.

For example, low-rated U.S. bonds of Hopson Development Holdings have gained 25 percent this year. Among the company’s biggest debt investors as of June were Asian firms Value Partners, Eastspring Investments and BEA Union Investment, data compiled by Bloomberg show.

And investors have decided to ignore stock performance. The dollar-denominated junk bonds of developer Fantasia Holdings Group have gained more than 7 percent since the end of July, while its stock has plunged about the same percentage in the same period. Value Partners is also one of its biggest debt holders, according to Bloomberg data.

Investors are clearly committed to this debt, but it’s not clear whether all these companies can remain solvent long enough to repay it. And China has made it clear that it’s not going to prop up any borrower that’s headed for bankruptcy.

Kaisa Group Holdings became China’s first real estate company to default on its U.S. currency debt in April. It’s just the start, and more insolvencies are expected as $12 billion of debt comes due this year.

The rally in dollar-denominated Chinese junk bonds is mirroring the nation’s property bubble. At some point both are going to deflate.

*The author has written about debt markets at Bloomberg since joining the company in 2010.

By Lisa Abramowicz