Why investors should avoid ChinaCo USD high-yield

Author: | Published: 14 Nov 2012
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Chinese real estate companies this month reentered the high-yield space. But bankers and lawyers have warned there are significant risks in the structuring of Chinese offshore high-yield offerings.

Although Chinese real estate companies have actively participated in the high-yield bond market – with a $1 billion Regulation S offering by SOHO China this week – their structures offer little recourse to offshore investors in the event of a default.

Speaking at a high-yield conference co-sponsored by Latham & Watkins and the Asia Securities Industry & Financial Markets Association (Asifma), market participants warned that the subordinated structuring of these instruments meant that they are equities and that they carry enormous risks.

A senior lawyer at a Chinese law firm made it clear that these high-yield bonds are not Chinese bonds but rather British Virgin Island (BVI) or Cayman Island bonds – offshore jurisdiction bonds that then invest in the equity of the Chinese company. This means the bond investors are in a structurally subordinated position.

"I believe the Chinese government knows this and is fine because it isn’t interested in the moral obligation that might be attached to foreign debt," he said.

Offshore holders only have stakes in the offshore holding company or special purpose vehicle. They do not have any security over the Chinese company’s underlying assets. Therefore they are subordinated to onshore creditors, and have few legal options if the company defaults.

There have been examples of disastrous defaults in the last few years but few situations in which offshore holders have had recourse.

"This is a stupid financial instrument from a credit point of view and to some extent is like the structured credit products which were at the heart of the global financial crisis," the panelist commented.

The abysmal recovery rate from these instruments is a significant concern.

"I leave it to you to decide what you think, but keep in mind that out of 110 issues in the offshore Chinese bond market, eight have already defaulted, which gives you a 4% default rate and only a 7% average recovery rate," he said.

Moreover panelists noted that it is in an issuer’s interest to immediately default on an instrument. Although it makes financial sense, it is unlikely because legitimate real estate markets need capital on an ongoing basis; a default would mean that the company would be unable to access the capital markets. It could also affect an issuer’s listed company if listed in Hong Kong.

But there are precedents for multiple defaults.

The panelist observed that in the Asian financial crisis in 1997-98, there was a string of so-called strategic defaults by companies in Southeast Asia. These were defaults by companies that didn’t have to default but chose to default – often because their peers were defaulting.

He predicted that this could be the same in China as bank lending becomes more complicated.

But another panelist said that Chinese companies might be unfairly targeted because of Muddy Waters and other groups. "It is unfair to attack all Chinese issuers when Indonesian corporate governance is also a concern," he said.

For more on Asia’s capital markets, please attend IFLR’s Asia Capital Markets Forum on Thursday, 15 November at the JW Marriott Hotel. More information can be found here: http://www.iflr.com/ACM2012

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