When the Shanghai-traded bonds of conglomerate China Minsheng Investment Group plunged 40 percent over two days in January after news it had missed a repayment, Beijing-based hedge fund manager Jash Zhang smelled blood.
As the private investors in the bond rushed to sell, Zhang snapped up CMIG's dumped bonds at about 50 yuan ($7.48) apiece, or half their face value, betting that the 300-billion-yuan company would eventually repay the debt.
The strategy,she said, is simply to pounce when faint-hearted investors are wavering.
"When bad news breaks about an issuer, some funds will scramble to sell the bonds," said Liu Xiaofang, head of investment research at Shanghai Fengshi Asset Management Ltd, which launched its first vulture fund in September. But the bonds' underlying problem might be "not that big," creating opportunities.
Zhang and Liu are among a new flock of vulture investors that have emerged in China's corporate bond market in the last year, seeking to profit from steep sell-offs.
The risky but potentially lucrative business of trading in bonds on the verge of default is in its infancy in China, almost as new as the phenomenon of corporate defaults in the state-run economy.
A regulatory source said only a handful of other hedge funds have entered the trade, including Lanjing Investment, Colight Asset Management, Jing Tang Investment and Yongle Fund Management. The source declined to be named because of the sensitivity of the matter.
By some estimates, the market in such distressed bonds is worth just 10 billion yuan ($1.5 billion), a tiny fraction of the $472 billion corporate bond market.
But analysts expect it to grow rapidly as the country's default wave, driven by funding squeezes in the private sector, claims more victims.
The strategy of trading in distressed bonds is more commonplace in mature markets, with recognisable names such as Elliot Management and Aurelius Capital known for their aggressive recovery tactics.
The emergence of vultures in China, spurred by a record number of delinquencies in 2018, could help improve liquidity in a corporate bond market that has traditionally been dominated by low-risk investors such as mutual funds, brokers and insurers.
In all, 45 companies in sectors ranging from real estate to industrials and mining defaulted on 117 bonds with a total principal amount of 110.5 billion yuan in 2018, according to ratings agency Fitch.
That is more than all the previous years' sums combined. China's first bond default occurred in 2014.
"The (Chinese) government did not really allow defaults to happen until about four years ago," said Ben Zhu, a Hong Kong-based distressed debt investor. "As defaults spread, the bad apples get picked out. These companies will lose access to financing, and that's a good thing."
For Liu of Fengshi Asset Management, the game of hunting for "fallen angels" has been highly profitable.
Last November, when Kangmei Pharmaceutical Co's debt instruments dived on a wave of negative reports suggesting reckless fundraising and insider trading by the firm, Liu bought for 70 cents on the dollar one of its bonds that would mature soon.
"The market consensus was that this company was cooking books. But we didn't think the problem was big enough to lead to an imminent default," Liu said.
Kangmei paid investors in full the next month.
"On an annualised basis, it's a return of several hundred percent. On an absolute basis, it was a gain of around 40 percent. And we bet heavily," he said.
More audacious investors like to buy bonds that have failed to repay investors on time.
"There's too much panic around defaults," said Zhou Li, president of Rationalstone Investment. "Whenever a company defaults, people would assume the (bond) value would be wiped out to naught. But that's not the case."
He added that not all technical defaults - such as a delay in payment - would lead to genuine defaults. And some or all of the money can be recovered, he said, making bargain hunting profitable.
Distressed asset specialists previously active only in lending markets are now venturing into troubled bonds. Guoho AMC, a bad-loan company in eastern Anhui province, is one example.
"We see mutual funds dumping them in the market. They have to. For them, it's toxic," said Liu Zhenhua, Guoho's Shanghai general manager. "But as a bad-loan company, we're good at assessing its value. You need an eye to spot gold in a junk market."
Sceptics say this money-making model will falter in China.
Desmond Kuang, portfolio manager at Income Partners Asset Management in Hong Kong, said the typical strategy would be to buy into cheap bonds after thorough research and with some conviction that the investment can be recovered. That may not work in China, he said, where there is a lack of transparency in company disclosures.
"There will be a lot of luck required onshore," he said.
Fengshi Asset Management's Liu said the risks could be big, and such a strategy would typically require clients with strong nerves to commit their funds for three to five years.
"It's a gamble. And you're betting against professional institutions, not layman retail investors," Liu said. "This game is very demanding in your ability to identify and assess risks."
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