* No last-minute rescue for Chaori to avoid bond default
* First domestic bond default to force re-assessment of credit risk
* More defaults expected after explosion of corp debt
* Markets calm, but investors may shun risky debt (Updates to confirm default; adds bond market reaction)
By Gabriel Wildau
SHANGHAI, March 7 (Reuters) - China recorded its first domestic bond default as expected on Friday when loss-making solar equipment producer Chaori Solar missed an interest payment, setting a landmark for market discipline in the world's second-largest economy.
Shanghai Chaori Solar Energy Science and Technology Co Ltd warned this week it could only pay out less than five percent of the 89 million yuan ($14.5 million) in interest due on 1 billion yuan worth of bonds issued in 2012 .
After a series of near misses in recent years, in which local governments stepped in at the last minute to bail out local champions, analysts say the precedent-setting default is likely to force a re-pricing of credit risk in a market that long assumed even high-yielding debt carried an implicit state guarantee.
"The Chaori default goes to show the government will begin to let the market decide the fate of weak borrowers. This test case indicates the government is addressing the moral hazard issue," said Christopher Lee, managing director of corporate ratings for Greater China at Standard & Poor's in Hong Kong.
"Incidence of defaults will likely be incremental but controlled," he said, nominating metals and mining, shipbuilding and materials as the key sectors with high default risks.
Chaori did not answer calls seeking comment on Friday. The Shenzhen Stock Exchange, where the bond trades, closed at 3:00 P.M. China time (0700 GMT) without any additional disclosure from Chaori, which would have been required if it had to amend its statement that it would not be able to make the payments.
Markets were mostly stoic ahead of the expected default. The benchmark seven-day bond repurchase rate was at 2.42 percent, its lowest since 2012. That weighted-average rate had briefly spiked on Wednesday after Chaori announced it would default.
The Shanghai Composite Index has lost about 1 percent since Tuesday's close.
"A default would likely make investors recalibrate their risk-return consideration for onshore bonds," Ivan Chung, senior credit officer at Moody's Investor Services in Hong Kong, said in a note.
"Credit risk would play a more important role in pricing, thereby making the bond market more efficient in the allocation of capital."
Indeed, yields on risky corporate bonds have risen since Chaori said it was set to default. The benchmark yield on five-year notes rated AA- AA-IC5YY=CDC was at 7.94 percent yesterday, up from 7.80 percent on March 4.
Chaori narrowly avoided a bond default in January 2013 after a Shanghai district government persuaded banks to defer claims for overdue loans.
This time around, the 21st Century Business Herald reported on Thursday that Chaori had financing lined up that would have enabled it to meet the interest payment, but the plan fell through at the last minute.
"This default was totally unexpected. We already had an interest payment plan in place. But because the counterparty suddenly changed his mind on the morning of March 4th, we had no choice but to default," the paper quoted an unnamed senior company executive as saying.
Nevertheless, a reassessment of credit risk in the world's second-largest economy appears to be underway. Three low-rated companies announced postponements to planned bond sales on Thursday, citing deteriorating market conditions due to Chaori.
In the near term, analysts predict that demand for riskier credit would fall.
"We suggest investors avoid buying low-rating bonds issued by private firms in near term due to worsening liquidity and potential default risks," Wang Ming, partner at Yaozhi Asset Management Co in Shanghai, wrote in a note on Wednesday.
"We think first credit bond default will change trading patterns of China fixed-income market and the treasuries and (treasury futures) markets are likely to be more active as a result," Wang wrote.
Such an adjustment appears well justified, as analysts expect more defaults on loans, bonds and shadow-bank credit this year. Local governments and firms in industries suffering from overcapacity are the focus of concern.
Last month, a high-yield investment product issued by Jilin Province Trust Co Ltd and backed by high-interest loans to a struggling coal producer failed to repay investors on maturity.
Ratings agency Standard & Poor's estimates overall debt in China reached 213 percent of GDP last year, up sharply from 140 percent in 2007. Corporate debt comprises the bulk of this total.
China's domestic bond market was worth 9.3 trillion yuan ($1.5 trillion) at the end of 2013. The overall bond market, at 29.7 trillion yuan, is the world's third-largest after the United States and Japan.
Also on Friday, media reported the Shanghai government had approved the launch of a bad-loan bank to buy bad assets from local banks and other financial institutions. China Business News said a source close to the bank said the first purchase may be of troubled loans to Chaori. (Additional reporting by Umesh Desai in HONG KONG; Editing by John Mair)