Understanding Bond Defaults from a Fund Manager's Perspective

How can default be seen in a positive light?

Kate Lin 15 December, 2023 | 13:55
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Kate Lin: Welcome to Morningstar. China property developer bond defaults have been making headlines. News sentiment around these defaults has always been gloomy. But defaults aren't always a negative occurrence. Why is that? Today we have Arvind Subramanian from Morningstar to share his thoughts on defaults.


An Opportunity for Highly Skilled Managers

Arvind, credit investors often fear debtors not repaying their loans. How can default be seen in a positive light?

Arvind Subramanian: Thanks, Kate. So our recent report highlighted the perils of bond defaults in a fund. But yes, there could be occasions where an asset manager would intentionally buy a defaulted bond if the price of that bond has already factored in an eventual default, in the hopes of reaping a recovery in the future.

Hence, just the mere presence of a defaulted bond does not always mean that investors have suffered. However, this requires precise timing and expertise on the part of the manager.

A Recent Example: Sri Lankan Sovereign Default


Lin: This is interesting. Can you give us an example that can illustrate this?

Subramanian: Sure. An interesting example would be the Sri Lankan sovereign bond, which defaulted in May 2022. At the time of default, the bond price fell to as low as 25 cents on the dollar. However, subsequently on the back of debt restructuring efforts from the country and potential support from the International Monetary Fund, the bond price actually recovered to an extent. As a result, these sequence of events actually offered investors a chance to reap benefits amidst that price rebound.

In our analysis, we found out that several emerging market debt funds were actually able to capture this price rebound in a timely manner. However, on the other hand, several Asian high yield funds actually failed to capture this rebound, and some of them even trimmed at the time of default.

What Can Investors Do In the Face of Bond Defaults?

Lin: So when a bond issuer is on the verge of default, what can investors do?

Subramanian: Yeah, it's important for investors to understand that often the price of a bond declines several months prior to the bond default itself. This is because often market participants tend to anticipate the deterioration in the financial condition of the issuer, and the bond prices start falling well in advance. When investors evaluate funds, which hold bond defaults, it's important to look at not just the portfolio weighting at the time of default, but also look at the holdings of the portfolio several months prior to it because that is when the bond prices tend to decline and investors tend to suffer the most. For example, Country Garden, despite its recent default, the bond prices of Country Garden were falling several months prior to the default itself. Interestingly, on the date of default, which was earlier this month, the bond prices were languishing at close to 5 cents on the dollar already.

Lin: Right, and to wrap up, when it comes to bond fund investing, can you share some rules with the default rate and manager selection?

Subramanian: Sure, so unlike traditional bonds, defaulted bonds often suffer from poor trading liquidity and also have wide bid-ask spreads. As a result, it poses challenges to an asset manager in portfolio construction and could also perhaps increase the transaction costs. Investors should also be cautious about the often lengthy debt resolution process. For example, Evergrande, it's been two years since the bond is defaulted, and there is still uncertainty around its debt resolution. Having said all of this, and as a result of all of these challenges, it's important for an asset manager who expects to capitalize on this space to have dedicated resources and team members with a specific skill set, which is required to participate in this space. That's very clear.

Lin: Thank you, Arvind. For Morningstar, I'm Kate Lin. 

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Kate Lin

Kate Lin  is an Editor for Morningstar Asia, and is based in Hong Kong

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