1. This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion of our investment managers
at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no
indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private
Capital is an SEC Registered Investment Adviser.
Thought for the Week (292):
Failure Can Be Good
Synopsis
Late last week, China experienced its first corporate bond default as the solar panel maker, Chaori Solar, failed to make an interest payment.
Although the payment was relatively small at 89.9 million yuan ($14.7 million), several market pundits in the media are calling for a domino effect, which could lead to a credit crunch.
The Investment Committee disagrees and actually applauds these types of failures in markets as controlled as China, because “moral hazard” is reduced and risk is more accurately priced.
China Finally Allowed a Default
Late last week, China experienced its first corporate bond default as the solar panel maker, Chaori Solar, failed to make an interest payment. Although defaults are commonplace in the U.S., China’s local governments have historically bailed out companies that are close to missing payments on loans.
The reason for most bailouts is almost always politically motivated. Local officials in China often fear that a default would damage their career prospects, and the potential economic concerns surrounding unemployment from a failed enterprise in their region/district have encouraged bailouts in the past.
NOTE: China is still a communist society and one of the biggest fears (if not the biggest fear) is unemployment, because rising levels often lead to political unrest. Communist societies cannot allow civil unrest because their leaders view protest to be an indication that their way of government is flawed.
As a result, investors have often viewed bonds in China to have implicit government backing, which is something that has benefitted China greatly and fueled a rapid credit boom since 2009 to a total size of $1.4 trillion. Since many investors felt that corporate bonds were as safe as government bonds, they chased those bonds with the highest returns with no concern for default risk.
Failures Are Needed in Markets
Government bailouts are almost always a bad outcome for markets in the long run because they create a disincentive for companies to practice financial discipline and investors to pay attention to the risks associated with an investment opportunity.
Therefore, the Investment Committee actually views this default as a positive for the global economy for three reasons:
1. Reduces Moral Hazard: A “moral hazard’ is a situation where one party takes risks because any negative outcome due to their actions will not be felt by them. The radical change from China’s past behavior of bailing out troubled companies sends a message to other firms that there will be consequences for mismanagement.
2. Push Needed Reform: This minor default will likely incentivize investors and regulators to pursue reforms in investor protection via covenants and better disclosures and governance. The net result should attract additional investors into their debt markets as they evolve.
2. This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion of our investment managers
at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no
indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private
Capital is an SEC Registered Investment Adviser.
3. The Concept of Risk Has Now Been Introduced: Lenders and investors will become more disciplined because they can now lose money. Furthermore, we expect to see a more efficient allocation of capital among corporate borrowing. Meaning those firms with less risk will pay less to borrow, and those with more risk will pay more to borrow.
Think about a twenty-something who is not so great with money and spends wildly on a credit card for several years. If this individual’s parents kept paying off the debts, then one could argue that he/she will never learn financial discipline.
Well just as individuals must “learn the hard way” at times, companies must also endure failure in order to realize that there are consequences to financial mismanagement.
Implications for Investors
The Investment Committee sees little to no risk of a “domino effect”, or a chain reaction that occurs where a small change causes a similar change nearby which can accelerate over time, for three key reasons:
1. Default Was Small and Expected: The solar industry in China has too much competition and weak pricing, resulting in a very difficult environment to generate earnings. Chaori had a history of financial issues due to these factors, and the size of the default is miniscule when compared to what ignited the financial crisis here in 2008.
2. China Has Far More Power: China lacks the inefficiencies that exist in our government to act quickly (a.k.a. “Congress”) and can attack any systemic crisis if one were to ignite. Their government would likely intercede immediately, and they possess the financial resources to extinguish nearly any financial fire.
3. China Learned from Our Mistakes: The collapse of Bear Stearns, Lehman Brothers, and other notable financial institutions taught the rest of the world a harsh lesson. China not only has the firepower to quell a liquidity crisis but also the knowledge of forewarning, having watched the U.S. go through our own lessons
The bottom line is that failure is often good for economies because the lessons learned will likely make markets more reliable. Companies must be penalized for borrowing more money than they can handle, and those firms who are in worse financial shape should be required to pay a higher interest rate if they choose to pursue more debt.
Similarly, if an investor pays little to no attention to the inherent risks of an investment, then he/she should be subjected to a loss in the event of a company default. Just as a child will rarely touch a hot stove twice, the investor will likely be far more cautious the next time that they are presented with the opportunity for higher returns with no regard to the risk involved.
