If you have been reading on Bloomberg, there have been some issues with China offshore credit lately. The Asia high yield bond market is dominated by China, which is in turn dominated by the property development sector.

As a result of the collapse of US dollar denominated Chinese property developer bonds, bond yields have gone above 20% on average and refinancing is impossible for many of these names. Many bonds are trading at stressed or distressed prices – with certain borrowers having already defaulted on offshore bonds.

Some prominent stressed borrowers include Evergrande (the most prominent one), Kaisa, Fantasia, Modern Land, Sinic, Aoyuan, Sichuan Languang, Sunshine 100, Yuzhou, Shimao, Agile, Guangzhou R&F Properties, Zhongliang, Ronshine, and Zhenro Properties.

As such, investment bankers in DCM / Leveraged Finance (which is somewhat blended at the Bulge Brackets in China / Hong Kong) are having very limited origination and accordingly fee revenue in 2022 after a series of robust issuance years.

What are some issues with China credit that have caused these issues and why were they ignored for so long? We look at addressing some of these here.

Offshore Bond Credit Issues in China

A number of issues that come to mind for China credit. These are not unique to China property, but are coming to the forefront in this sector just owing to the sheer volume of property bonds.

Perhaps the most prominent is relatively weak financial disclosure. The bonds are usually issued in Singapore or Hong Kong and governed under foreign law (often New York). The entities that issue the bonds may be in the Cayman Islands. Meanwhile, management and directors are often in Mainland China.

While semi-annual and annual financial reports are required by the exchanges in line with the rest of the world, the quality of reporting can vary. There may be off-balance sheet liabilities that would in an ordinary case count as debt but not have any mention in the financial statements. This can seriously understate the amount of debt in terms of figuring out leverage ratios and the ability of the company to service its obligations. Additionally, many accounts may not be reconciled easily – with auditors having challenges verifying accounts.

As an extension, credit rating agencies (major rating agencies Moody’s, S&P and Fitch are all in China – with Fitch having a stronger presence there than they do globally) rely on these financials at face value and accordingly may make less than accurate assessments. Chinese rating agencies are far more liberal, giving top investment ratings while the Big 3 generally will assign sub-investment grade ratings to most corporates that issue offshore.

There are also recurring corporate governance issues with Chinese issuers. These issues will probably remain until there is regulatory pressure to rectify them. As investors know, the fiduciary duty of management lies with shareholders and not bondholders (until the company is financially distressed or bankrupt) – however, for many companies it is questionable if they even adhere to the fiduciary duty to shareholders (aside from the controlling or influential shareholder, often the Chairman).

Legal frameworks are far less developed and enforceability is challenging – even in cases which are clear cut in the US. Examples include fraudulent conveyance and other bad faith actions – including misleading disclosures. There are limited ramifications for moving assets available to bondholders where they cannot seize them or selling them below market to related parties (possibly controlled by influential stakeholders). There is also no established bankruptcy process like a Chapter 11 in the US.  

It is important to differentiate between offshore bonds and onshore bonds. Onshore bonds are issued in RMB in China and are structurally senior to the offshore bonds, who would be at the back of the line for any sort of liquidation scenario. Onshore bonds have much lower coupons and can be competitive with bank debt – although the investor base is also dominated by commercial banks and wealth management products. Most of the issues that investors are facing in the news are from USD denominated offshore holdings.

Outperformance of China High Yield

Now it is debatable who on the buy side actually does real credit work. There are index huggers in every investing jurisdiction – and there are a lot of investment managers who will buy something because someone else is buying without a cursory glance at the financials. As bad as it is and with the occasional default here and there, markets in the U.S. and other developed markets are generally efficient enough where you may underperform but probably not have a -10% year.

Overall, Asia focused funds are fairly limited in size as a percentage of the global high yield bond market. US hedge funds who are looking to make a play in China property (and the ones who didn’t go short are generally nursing losses broadly speaking) are putting in a very small percentage of their total investing books – and usually at a substantial discount to par.

Overwhelmingly, most borrowing in China and developing markets in general is bank debt. This is usually the case until a country starts to have deep and mature capital markets.

The ownership profile of losers to date varies – but a large number reflects high net worth individuals in Hong Kong and Mainland China who have levered up for enhanced yield.

The reason why the market got so big is because until 2021, this was a carry trade that worked. Without much credit work, investors saw that the property sector kept getting bigger and bonds always got rolled over (refinanced). Also, the financials looked pretty good – only when the tide comes down do you find out who is swimming naked.

In the end, the solution for low prices is usually low prices. The cost of capital is prohibitive for borrowers right now – so until investors generate comfort with stronger covenants and become confident in the collateral available, borrowers will likely be locked out. If you lend unsecured, you can get a zero – especially if all the assets are onshore and you are lending behind a variety of other stakeholders (with some of them not even being creditors).