It is well known that international bond investors have loaned tens of billions of dollars to Chinese companies in recent years and that some of those companies, notably Sino Forest and China Forestry, are now in distress.
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Less well known, however, is the fact that almost every Chinese borrower that has tapped the international markets for funds has done so through a circuitous route that exposes investors to considerable risk.
Distressed debt specialists and insolvency experts say many investors have failed to appreciate the dangers and are likely to suffer big losses when these bonds come due in the next few years.
“Even if the bondholders get their money back in five years, they are not being paid an appropriate rate of return,” says Tom Jones, co-head of Asia for Alvarez & Marsal, the restructuring firm.
“They have been taking equity risk for a bond return,” says Mr Jones, who predicts trouble ahead for the asset class.
The structural flaws of Chinese offshore bonds are not new and are well known to more savvy investors in the market. But with more than $33 billion raised through such deals since the start of 2010 – five times the issuance of the entire preceding decade – the risks are more relevant than ever before.
Much of the recent investment has come from less experienced operators, such as the clients of private banks in Asia and US and European fund managers hunting for yield in emerging markets.
China’s strict capital controls prevent private mainland companies from borrowing from foreigners directly. Only the most powerful state-owned enterprises are able to get regulatory permission to do so.
To get around the restrictions, most Chinese companies issue bonds through offshore holding companies or special purpose vehicles, then send the money onshore in the form of foreign direct investment – that is, as equity rather than debt.
This structure carries several risks for bondholders. For a start, foreign investors are essentially buying bonds from an empty shell that, in turn, owns a stake in the operating company in China; they have no direct security over the underlying assets. Since the offshore bonds are not counted as debt on the balance sheet of the mainland company, foreign bondholders are subordinated to onshore creditors – meaning they are unlikely to recover much cash if a company goes bust.
Defaults by Chinese groups, from Guangdong International Trust and Investment Corp (Gitic) in 1999 to Asia Aluminium in 2009, have repeatedly shown that investors who loaned money to offshore holding companies can do little when things to wrong.
After the collapse of FerroChina, a steelmaker, in 2008, onshore creditors managed to walk away with a portion of their cash in one of the first tests of the mainland’s long-awaited new bankruptcy regime, but offshore creditors got nothing.
While foreign bondholders can easily take control of an offshore holding company after it defaults, the chances of them then being able to enforce control of the onshore operations are extremely slim.
“As very rarely does an enforcement work, it is usually more a theoretical rather than practical issue unfortunately,” says Scott Bache, Hong Kong-based partner at Clifford Chance, the law firm.
Yet the prospect of recovering little or no money should a company default is not the only risk for investors.
For many, the bigger concern is that under Chinese regulations, a mainland company cannot easily send money offshore to service the interest and principal on its foreign debt.
Having received cash from an offshore bond sale in the form of an equity injection, the onshore company may only send money back to the offshore entity in the form of after-tax dividends.
Dividends can only be paid when the company is making a profit. Sending them offshore requires regulatory approval.
“Basically the foreign bondholders are taking the equity risk,” says Ivan Chung, a Hong Kong-based senior analyst at Moody’s, the rating agency.
And since onshore cash flows will be too small to cover repayment of debt offshore for most Chinese companies, in due course they will need to borrow more money from the offshore markets to avoid defaulting.
“We will start seeing more refinancing needs from 2014, that’s when you will know whether that market has worked or not for investors,” says Michel Lowy, co-founder of SC Lowy, the Hong Kong-based trading and investment firm focused on illiquid assets.
“It needs to be highlighted to investors that they’re not going to get their money back unless there’s either a vibrant equity or refinancing market offshore for those borrowers.”
In Mr Lowy’s opinion, yields on Chinese high-yield bonds would need to hit 15-20 per cent before they were high enough to compensate for the risks. The high-yield market is currently yielding about 9 per cent, with yields on the bonds of property developers now in the low double digits.
Most market participants reckon such a view is too bearish.
Endre Pedersen, who runs an Asian bond fund for Manulife Asset Management, says that for investors with the research capabilities to “cherry-pick” the best companies, the returns on Chinese bonds are attractive, especially when compared with companies or governments in the west.
The structural drawbacks of Chinese bonds are simply an unavoidable part of investing in one of the world’s fastest growing economies, he says. “It just means that you’ll be punished more if you get it wrong compared to other markets.”