Chinese bonds: Issuers cloud the meaning of default
Creative strategies to avoid the appearance of non-payment are becoming more common in China’s domestic bond market. That leaves many investors at a disadvantage and uncertain of their rights.
Chinese companies have come up with some pretty novel tactics to avoid looking like they defaulted on their domestic bonds.
In recent months, some issuers have tried lowering their coupons, extending payments, making private payment arrangements with certain bondholders while ignoring the open forum of the exchange where their bonds are listed, or offering investors a take-it-or-lose-it swap offer – all to avoid the shame and consequences of a very public default.
Perhaps this is not a surprise, given the number of defaults that have occurred. In the first five months of 2020, 23 Chinese issuers have defaulted on 53 bonds, worth a total of Rmb66.2 billion ($9.3 billion), according to Wind. That is equivalent to 45% of all the defaults that took place in 2019 (totalling Rmb147.6 billion), and more than half of the Rmb121 billion in defaults in 2018.
Seven of the 23 issuers this year were first-time defaulters.
While the defaulted amount is only a fraction of the size of China’s Rmb36.2 trillion onshore ‘credit bond’ market – mostly bonds issued by financial institutions and corporates – the upward trend is starting to alarm investors.
Go back to 2017, and issuers missed payments on only Rmb39.4 billion of domestic deals. Since then, economic growth has slowed and China has cracked down on shadow banking.
Some private companies that used debt to fuel their expansion in recent years have become more vulnerable, while in the public sector, Beijing and the local governments have been less willing – and in some cases, less able – to rescue failing businesses.
Investors seldom get much of their money back in a default situation. Since the first default in China in 2014, issuers have only managed to repay Rmb31.8 billion, according to Wind – a relatively small proportion of the total defaults during the last five years – while well over 400 bond-related lawsuits have been filed in Chinese courts, public records show.
These problems worry investors. But in several of the most recent cases, it is not at all clear which of these examples constitute actual defaults. That is an important distinction because the existence of cross-default clauses means that many issuers are obliged to pay back most of their debt even if they only default on a small portion of the total.
A default also affects a borrower’s reputation: investors, analysts and regulators may forget a forced extension of debt, but they certainly do not forget a default.
Some default-avoidance tactics are confusing matters in the markets.
“The definition of defaults has been made very blurry,” says a debt capital markets banker familiar with China. “On one hand, investors did not get paid as expected because these issuers were not able to. But on the other hand, they [the investors] agreed to not getting paid. Is this a default or not?”
This is hotly debated in the domestic debt market, but there is little widespread agreement on the definition of default and whether or not it should include these fuzzier forms of avoiding repayment.
“We might see it as a default if an issuer only pays interest and extends the principal,” says Zhang Renyuan, director in corporate ratings from S&P Global (China) Ratings in Beijing. “No matter what kind of unconventional format it is in, creditors’ rights could be significantly undermined in an event of default.”
Debt bankers and investors are particularly alarmed by some of the ways borrowers circumvent the rules, for example talking to investors privately about debt repayments as a way of bypassing the oversight of the clearing houses.
It is a move seen by domestic debt bankers as an act of desperation to avoid a public default. By cutting out the clearing system, the issuers do not have to announce any payments or, more importantly, non-payments.
In March, Shandong-based conglomerate Zhongrong Xinda Group, which is in the business of financial investment, chemical, energy and mineral resources, said 14 bondholders had unanimously agreed to allow it to privately pay the annual coupon of a Rmb1.5 billion, 7.5% five-year deal.
But the company later announced it had only paid interest to holders of Rmb390 million of the notes, having convinced those who hold the remaining Rmb1.11 billion to wait until September.
While time is needed for these new rules to be properly implemented, one thing is for sure – that regulators are sending out positive signals and pointing to the right direction - Zhang Renyuan, S&P Global (China) Ratings
Yihua Enterprise (Group), a conglomerate operating in the lifestyle, medical and healthcare, hospitality, real estate and finance sectors, pulled off a similar move late last year. It only wired the interest of the Rmb1.175 billion put portion of a bond to the clearing house, with the principal amount paid privately and directly to bondholders.
Clothing and textile firm Shandong Ruyi Technology Group took the same route, securing consent from all nine investors in its bond to delay a coupon on the Rmb1 billion deal, which also will be paid privately. These nine investors also agreed that the late interest payment would not constitute a default.
All three of these issuers also have bonds outstanding in the offshore market.
They did not respond to repeated requests for comment from Asiamoney.
Even though Zhongrong Xinda and Yihua managed to extend the repayment period for two of their bonds, they have since defaulted on other bond issues.
Market participants highlight a few core issues in China’s domestic bond market that contribute to the rising defaults and near-default activities.
Jim Veneau, head of Asian fixed income at Axa Investment Managers in Hong Kong, points to flaws in the pricing mechanism in the onshore market.
He says there is less diversity in pricing among onshore deals, increasing the risk that bonds from different issuers become treated as equivalent.
“The onshore pricing tends to be much tighter and much less volatile.
“What would bring about an acceleration in the legal framework and investor protections would be if there was more responsiveness and transparency in pricing of these bonds,” he adds. “Because generally speaking, bonds that have tighter investor protections in the offshore market have tighter spreads – the market will take that into consideration.
“This is part of the negotiation when the bonds are being issued. The secondary market should also be in play.”
There is also a problem of information disclosure. The disclosure standards for Chinese bond issuers are much weaker than those listed in the domestic stock market. That makes it difficult for investors to make informed decisions.
“Before a default happens, it is all about the information investors can get, but there is minimal standard for bond market information disclosure,” says Gary Ng, economist, Asia Pacific, at Natixis in Hong Kong.
Compared to the equities market, there are many things that bond issuers are not required to disclose, even a major M&A. The bar needs to be set higher - Gary Ng, Natixis
“The annual reports could be published very late with only the most basic information such as the balance sheet and P&L ratio, so it really comes down to how well you know that company,” he says.
“Compared to the equities market, there are many things that bond issuers are not required to disclose, even a major M&A,” Ng adds. “The bar needs to be set higher.”
The equity market is not perfect, but poor disclosure there at least leads to a reprimand from regulators.
For example, tech company Tatwah Smartech (Group), received a warning in April from the Shenzhen Stock Exchange for not disclosing, among other things, Rmb572.5 million of loan defaults from November 2018 until the end of April 2019.
HNA Group, a conglomerate with many businesses including aviation, finance, hospitality, tourism and logistics, is another example of a company that has not treated all its bond investors fairly.
The company, which attracted attention because of its aggressive expansion, is now better known for rocketing debt levels and high leverage from its past acquisitions.
Gary Ng, Natixis
HNA held a conference call with bondholders on April 14 at 8pm but only published an official notice announcing the meeting at 9pm – one hour after the call had begun.
The meeting was to propose the extension of a 7.1% 2020 bond, Rmb390.4 million of which remained outstanding. The notes were due on the same day, meaning HNA was in breach of its bond prospectus, which promised a 30-day notice for any bondholder meeting.
The company later issued an official apology for the hasty arrangement, but so far it has not been punished for its conduct.
Due to the last-minute nature of the meeting, some investors were deprived of their voting rights because they hadn’t registered in time. In the end, 32 investors, who held just under 90% of the bond between them, participated in the call; 29 of those investors voted against the extension plan, but the other three were much larger and held 98% of the voting rights at the meeting.
HNA passed all motions, including one that declared the meeting itself was proper despite the lack of prior notice.
HNA did not respond to requests for comment.
The current situation is more [about] protecting the issuers, and there needs to be a stronger initiative from regulators confirming the legal power of investors - Gary Ng, Natixis
Bond investors can call their own meetings in theory, as long as they hold over 10% of the outstanding amount of a bond in the exchange market, or 30% in the interbank market. In practice, though, investors with such large holdings tend to have direct relationships with issuers.
Smaller investors have little power and little recourse.
“While there is legal power of investors to hold the meetings, the decision may not be legally binding,” says Ng of Natixis. “We need to allow these meetings to represent investors. The current situation is more [about] protecting the issuers, and there needs to be a stronger initiative from regulators confirming the legal power of investors.”
Another problem is the bond trustee system in China’s domestic market.
Bond trustees are supposed to make sure that issuers stick to their promises. Among China’s regulators, only the China Securities Regulatory Commission (CSRC) has attempted to clarify the responsibilities of a trustee, saying the trustee should monitor the credit conditions of issuers, urge proper information disclosure, coordinate negotiations between issuers and investors and always be aware of repayment plans.
But the regulator also suggested that bond underwriters can act as trustees. That is a clear conflict of interest for debt bankers who can only survive by winning a steady supply of deals.
China’s new securities law, which came into effect on March 1, provides some clarity. The law states that when a default happens, the trustee should act on behalf of all or some investors to initiate or participate in civil lawsuits or the restructuring process.
That’s still quite vague.
One thing is for sure – regulators are sending out positive signals and pointing to the right direction - Zhang Renyuan, S&P Global (China) Ratings
A Hong Kong-based partner at an international law firm, who is familiar with Chinese clients, says the onshore trustee system is not really comparable with elsewhere.
“The onshore and offshore trust markets are completely different, and the duties and roles of the trustees are considerably different under the New York or English law and under the Chinese law,” he says.
“The nature of the trustee is going to vary from case to case. Post-default, the trustee can be extremely important. It also depends whether you have two or three parties holding a bond, or 200 to 300 investors. The organizational challenges mean some trustees have a more active role.”
He says this is something that international banks have flagged to the government, adding it is “on everybody’s radar”. But he says that market participants should not expect an immediate solution to the trustee problem.
Regulators are not ignoring the problems in the domestic market. In June 2019, the People’s Bank of China (PBoC) published draft guidelines on the trading of defaulted bonds in the interbank market.
In December, regulators released draft rules on information disclosure for corporate bonds, and held a meeting on court-mediated dispute resolution for bond defaults.
A few days later, the PBoC, CSRC and National Development and Reform Commission jointly released the draft rules on dealing with corporate bond defaults, and accepted feedback until January 11 this year.
The official regulation is yet to be announced, but the draft rules touch on key problems including improving the current trustee system and the mechanism of bondholder meetings.
“This is something they need to do, not just for the benefit of local investors but foreign ones too, especially if China wants to attract foreign inflows,” says Ng at Natixis.
“For now, the foreign players invest more in the safer treasury and policy bank bonds, but if regulators want to develop the corporate bond market, they’ll need to address this issue.”
Regulators such as the National Association of Financial Market Institutional Investors are also encouraging the use of exchange offers to dispose of default risk.
Earlier this year, Beijing Sound Environmental Engineering became the first in onshore China to complete an exchange offer – a common liability management and restructuring tool in the offshore market – on the bond’s due date, when 11 bondholders holding 80% of the original deal agreed to roll over to a higher-yielding bond that matures one year later.
The market also saw the first cross-border trading of a defaulted note from Peking University Founder Group in April, when an offshore investor was able to sell part or all of the distressed debt.
“The regulations from the end of 2019 were aimed at improving the default situation, including allowing issuers to exchange bonds that are about to default,” says Zhang at S&P Global (China).
“While time is needed for these new rules to be properly implemented, one thing is for sure – that regulators are sending out positive signals and pointing to the right direction.”