• 04/05/2015

Trouble Ahead for China’s Bond Market

Trouble Ahead for China’s Bond Market

By BM editor

A calamitous series of events in China’s bond markets is sending ripples of concern throughout the investor community. It started with the near collapse of high-profile Kaisa Group, an embattled Chinese property developer based in Shenzhen.

The Kaisa Group, whose shares were suspended from trading on the Hong Kong stock exchange for about a month from 24th December 2014, had run into financial difficulties, stemming from a diktat from Shenzhen’s city government to suspend sales at four of Kaisa’s urban property developments in the Shenzhen metropolitan area. Approvals for Kaisa’s construction and development projects were also suspended, as a result of ongoing corruption investigations. This led to a raft of senior management resignations, including Chairman and Executive Director Kwok Ying Shing, Vice Chairman and Executive Director Tam Lai Ling and Chief Financial Officer Cheung Hung Kwok.

The effect of such suspensions pushed the company close to bankruptcy – its Shenzhen development projects contribute more than 20% to total property sales – and on January 12th 2015, Kaisa announced that it had missed a US$23 million interest payment to HSBC. Adding to the group’s spiralling debt woes, at least 17 known financial institutions applied to the Chinese courts to freeze Kaisa’s assets, thus impacting Kaisa’s ability to access refinancing in capital markets.

During this period of turbulence, Kaisa’s debt briefly traded as low at 32 cents on the dollar as the question of repayment raised huge doubts. Kaisa’s bond prices have since rebounded, as rival property developer Sunac China Holdings Co., based in Tianjin, stepped in to announce that it would be making an offer for the troubled company. Sunac offered to pay HK$4.55 billion (US$587 million) in exchange for 1.53 billion shares, or 49.25%, of the indebted Kaisa Group, thus thwarting what could have been a messy wind-up of Kaisa’s debt obligations.

Nonetheless, it is not yet clear whether or not offshore investors will accept the undoubtedly significant haircut on their Kaisa debt holdings. In a recent proposal for the company’s debt restructuring, Kaisa bond maturities are to be extended by five years and coupons to be slashed, with an implied haircut of 50%. If bondholders do not agree to the terms, the proposed takeover by Sunac, which has set a July 31 deadline, could be at risk. Experts say that the 50% haircut is a good deal for investors, and lower than the 100% loss implied by an earlier analysis by Deloitte, especially as these bonds are typically subordinated unsecured notes with limited recourse in the event of a credit default.

Chinese Property Prices Slowing; 15% Vacancy Rates

China’s overall debt levels, including government debt, non-financial corporate debt, financial institutions and household debt, has ballooned over the past 15 years, growing from around US$2.1 trillion in the year 2000 to a massive US$28.2 trillion in the second quarter of 2014 and reaching 282% of GDP – higher even than some advanced economies such as Australia and the United States. A report from Mckinsey Global Institute estimates that nearly half of this debt is related to the real estate sector, which includes lending to households, to property developers, to construction-related industries such as cement and steel, and to local government financing vehicles.

With the expectation that the Chinese government would bail out any property developer at risk of default, offshore investors, in the hunt for high-yielding assets, had been loading up on Chinese property debt over the past few years – Kaisa bonds being one among them. It’s easy to see the attraction in these property developer bonds – China’s property market had been booming for years. From 2008 to the middle of 2014, an index of 40 Chinese cities showed that property prices had surged by an average of 60%. In Shenzhen and in Shanghai property prices rose even higher than the average, rising 76% and 86% respectively.

However, the slowdown in China’s property market (investments in the once red-hot property market slowed to a five-year low of 10.5% in 2014 from a year earlier, the slowest pace since the first half of 2009) has led to the creation of China’s ‘ghost cities’, where excess supply of housing has far outstripped demand. According to a report by Nicole Wong of Asian brokerage CLSA, around 15% of homes constructed in the past five years in China’s third tier cities are being left vacant. This number is projected to rise to over 20% in 2016-17, according to Wong. With such a glut of Chinese property up and down the country, average property prices in China have been falling for 10 months straight since May 2014.

Thus, across the real estate industry in China, margins are falling and interest coverage ratios are under serious pressure. Small and medium-sized developers, which make up the bulk of the industry, have been producing after-tax margins of just 8%, and with interest coverage ratios falling from 5 in 2011 to 3 in 2013, these companies in particular are more at risk from the downturn compared to their larger counterparts.

Chinese Businesses Face Increased Financing Pressures

As China’s real estate sector accounts for about a third of the country’s gross domestic product, any downturn in the property markets will have a huge impact on China’s economy overall. In January, China’s Ministry of Finance announced that its economy expanded by just 7.4% in 2014, missing its growth target of 7.5% for the first time in 15 years.

The slowdown in China’s economy is already being felt and there have been reports of more defaults in the Chinese private bonds market outside of the real estate sector. According to a recent Bloomberg article, three such defaults had been uncovered since the beginning of the year. Suqian Chief Leather Co. and Dongfei Mazuoli Textile Machinery Co., both based in the Jiangsu province, and NBO Machinery Equipment Co., a forklift maker based in Anhui, all reported difficulties in making payments on their debt obligations.

In response to a slowing economy and deflationary pressures, the People’s Bank of China (PBoC) unexpectedly cut interest rates by a quarter percentage point in November 2014– the first time since 2012 – throwing a lifeline to these troubled Chinese companies seeking financing. A further quarter percentage point cut to the benchmark rates in March 2015 reduced the one-year loan rate to 5.35% and the one-year deposit rate to 2.5%. However, this may not be enough to save some of these smaller companies.

Select Chinese Property Developers Still Able to Issue Debt

Despite Kaisa coming to the brink of bankruptcy and the brief resulting lull in demand for Chinese debt earlier this year, it seems that investor demand for Chinese bonds has already come back to the fore. Shanghai-based Shimao Property recently announced the successful placement of US$800 million in senior unsecured notes with HSBC, Standard Chartered Bank, Goldman Sachs, UBS, JP Morgan, Morgan Stanley and CLSA. The bonds are rated BB- by Standard & Poor’s and BB+ by Fitch and is the first issue from a Chinese property developer since Kaisa’s wobble.

A research note from Standard & Poor’s, a ratings agency, stated that Shimao’s “increasing property sales and cautious land acquisitions will largely offset an increase in debt owing to expanding operations in 2015.”

Thus, investors’ hunt for yield continues. That financing is still available to property developers able to persuade of their merits suggests that the risk of a potential outsized loss isn’t enough to put investors off the glossy allure of China’s high-yielding bond market. Caveat emptor. BM