Asiamoney, China - Mon March 12, 2012

Clarity vital for China’s budding high yield bond market

The country’s regulators are looking to roll out a high yield bond market to help smaller businesses find funding. But fostering investor confidence won’t be easy given the opacity around bonds, red tape and untested rating agencies. Anita Davis and Elliot Wilson report.

How can a deliberately opaque, government-controlled bond market develop a thriving, responsible high yield one? Beijing is trying to find the answer.

On February 6 the China Business News reported that the China Securities Regulatory Commission (CSRC) had met with securities firms and rating agencies to tell them about plans to launch the country’s first regulated junk bond market.

It was big news. The country’s small- to medium-sized enterprises (SMEs) have long been struggling to gain credit lines they badly need from local state banks that have been instructed to lend less by central bank diktat.

Desperate for cash, many have borrowed from loan sharks or non-financial companies (which are frequently just larger corporates), in a growing industry known as shadow banking. Typically companies borrowing this way are charged extortionate interest rates, while the potential for unchecked debt exposures has proliferated through the Chinese economy.

Given this environment, fostering a high yield debt market makes sense. It would give SMEs a credible funding pool to innovate and expand – which Beijing wants as it strives to keep economic growth above 7%. It’s a pity, then, that China is so poorly positioned to move ahead.

Most bond bankers, investors, and market experts that Asiamoney spoke to believe that a junk bond market will struggle without sizeable reforms.

This scepticism is well-founded. China is far from being a proponent of financial market transparency, yet such visibility is essential for a corporate debt market – particularly on the lower end of the credit spectrum.

Added to that, the regulators want to launch the market at a time when confidence in high yield bonds from the country is at a long-time low.

This scepticism is partly because of global economic volatility. But investors also became alarmed last year by revelations that some offshore-listed companies such as Sino-Forest, China Forestry and Harbin Electric have question marks about their financial viability and the accuracy of their ledgers.

If China-affiliated companies that list overseas and issue international debt can end up accused of fraud and financial weakness, it’s highly likely that some smaller local SMEs would face similar allegations.

Such concerns make developing a low-grade bond market a tough sell.

“It’s a very ambitious plan to push out high-risk products like these in 2012,” says a China-based financial lawyer. “If you are experiencing problems with your companies’ corporate governance, if you’re planning for National People’s Congress meetings and if you’re preparing for an intergenerational change of power that will run until the end of the year, there’s just too much to do. This market will need some real dedication and the appropriate time to ensure its transparent development.”

Beijing needs to make some big changes to its market oversight and clarify the laws surrounding bankruptcy if it intends to build a junk bond market that works. And that will take time.

A liquidity squeeze

The CSRC’s intentions are good: the country’s SMEs are cash-hungry.

China is home to more than 50 million small and medium businesses that account for 80% of new jobs, according to the Ministry of Finance. These businesses are seen as a beacon of ingenuity; some will become the country’s next corporate success stories.

But leading industries continue to be dominated by state-owned enterprises (SOEs), which typically get top perks, including the best funding rates. Robert Zoellick, president of the World Bank, told senior Chinese leaders in Beijing on February 27 that the promotion of SOEs at the expense of the private sector – was “unsustainable”, as it marginalised private enterprise.

Beijing has belatedly recognised the need for SME growth. “There is a lot of political pressure to solve the financing needs of these SMEs, which provide most of the employment in this country,” says Ivan Cheah, managing director of Compass Advisers in Shanghai, where he works with mainland SMEs finding funding. “SMEs are starved for capital.”

Small companies particularly struggle to gain bank funding. China’s banking sector may boast a deposit-to-loan ratio of 70%, but state lenders have been instructed by Beijing to slow the rate at which they lend to cut inflation risks. As a result they have prioritised lending to SOEs. Large private companies come next, then big foreign businesses, with SMEs trailing.

SMEs have sought alternative ways of raising money. One such means has been shadow banking, a catch-all that includes a variety of lending by non-banks, some of which charge extortionate interest rates of up to 60%. Given its nature, the size of this market is hard to estimate, but in December the central bank said that shadow banking constituted more than 20% of the country’s total lending.

Private equity-like investment clubs that lend to needy companies are one source of funding that has proliferated in Wenzhou. Plus some SMEs effectively issue high yield bonds already, via an underground and unregulated market.

Finding the funds

Introducing a fully regulated high yield bond market would help China’s SMEs raise money through more legitimate and less costly means.

Conceptually it would offer the SMEs the money they need, while giving local investors healthy annual returns – in the form of yields up to high single or low double digits – to compensate them for buying debt from risky borrowers.

But there’s a big catch. High yield Chinese borrowers have become increasingly perceived as unreliable at best, and fraudulent at worst. The poor image stems from accusations and subsequent financial troubles that circled several high yield China-linked companies in 2011.

Toronto-listed Sino-Forest was accused of fraud by US-based short seller Muddy Waters in June. The forestry company refuted Muddy Waters’ claims, but it went on to miss a deadline to report its quarterly results in December and failed to make a US$10 million payment on US$1.8 billion worth of bonds that month.

The company avoided default in January after a group of bondholders opted to temporarily waive their right for immediate payback in exchange for a smaller amount of money and additional promises made by Sino-Forest’s management. That waiver is valid until the end of April.

Several other examples exist. Harbin Electric, based in Heilongjiang, delisted from the New York Stock Exchange in November 2011 following a spat between the company and critics led by Andrew Left of Citron Research and researcher-journalist Roddy Boyd.

Left and Boyd accused Harbin of being run fraudulently, causing the stock to fall to US$5.82 on June 16, 2011. That led to a public dust-up at a conference between Left and Harbin spokeswoman Christy Shue, who pointedly asked Left if he “got his information wrong”. Following the delisting, Harbin chief executive officer (CEO) Yang Tianfu said he was “tired of the US” and could “easily” relist the firm in Shanghai or Hong Kong – something that has yet to happen.

China Forestry and Focus Media have also been publicly criticised for alleged corporate governance weaknesses.

These issues have dampened investor enthusiasm. According to Dealogic, mainland corporates raised US$6.7 billion via 18 international high yield bonds in 2011, well under the US$7.9 billion issued through 21 bond sales in 2010.

The devil’s in the default

Beijing’s rulers are trying to minimise the risks of onshore high yield deals blowing up. The CSRC said it will only mandate credible SME borrowers with a strong track record of business accountability to sell their debt.

Exactly how this is defined is uncertain, but it’s likely that the companies will need to be publicly traded on indices such as the ChiNext growth board, the Shenzhen Stock Exchange’s platform for SMEs. Pending the success of such bonds, unlisted and Hong Kong-listed Chinese companies may follow.

That’s all well and good, but eventually a high yield company will default. There is a reason they are so lowly rated, after all.

What happens then? Nobody is really sure.

Formally, companies have to submit a notice of default to either the National Association of Financial Market Institutional Investors (Nafmii) or the CSRC, depending on which market they used to issue their bonds (Nafmii oversees the interbank market; the CSRC the corporate bond market), as well as to the local municipalities. The regulators then recommend that the borrowers repay the bond principal, or in drastic cases begin bankruptcy or restructuring procedures.

In practice few companies have been close to a default, largely because most borrowers are SOEs or big private corporates. And those that have had troubles have either had a parent company or affiliated division to bail them out (frequently a state holding company) or their investors, at the behest of the regulators, agree to roll the debt over. The latter is made easier by the fact that the largest bond investors tend to be banks using the bonds as another form of lending.

“If something were to happen to a bond, regulators encourage banks to resolve the issue and roll the debt over,” says Augusto King, co-head of Asia’s debt capital markets for RBS, who is also engaged in the bank’s joint-venture (JV) brokerage firm Huaying Securities. “The question regulators are asking themselves, though, is ‘are we really helping the system?’”

They are right to ask. Preventing defaults may be great for appearance’s sake, but it has stymied an appreciation of risk among bond investors.

“There hasn’t been a default in the Chinese bond market for years, so there will be a panic in the market when this happens,” says Ivan Chung, a Hong Kong-based vice president and senior analyst at Moody’s.

Nobody knows for sure how China’s bankruptcy laws would be applied – if at all – in the event of a default.

As Michael Ye, CEO of China Chengxin International Credit Rating, notes: “Developing the bond market is a national policy. But the healthy development of the junk bond industry may test the bankruptcy laws. How, for example, can creditors’ rights be realised? The recovery process is another problem. The market needs to be large enough and deep enough to deal with a few defaults.”

Theoretically investors can go to the courts to get their money back. But Moody’s Chung says it’s “hard to predict” how such legal proceedings might go with any bankruptcy – particularly given that a bond default could include hundreds, or even thousands, of investors.

“In Western markets, investors can sue the company and go through the process of liquidation,” he says. “But in China nobody knows what happens [in the case of corporate bankruptcy]. It’s the same with bonds – what happens when investors go to the issuer and try to get their money back?”

Covenant concerns

Experts say that three vital things are needed to create a responsible high yield bond market: standard documentation for financial covenants on high yield bonds; a legal requirement for companies to make full disclosure about major events; and a tried and tested trustee system.

In the first area, covenants or clauses set into a bond’s framework can minimise the chances of a borrower’s creditworthiness from deteriorating.

One useful initial covenant would be stipulations in the event that the borrowing corporate comes under new management control, giving investors the option to sell the bond back to the issuer.

Another would be a negative pledge clause – an indenture that prevents a company from using its assets to secure more debt if doing so changes the bond’s risk position. An additional covenant would be a cross-default clause, wherein an investor can claim a default on a bond issue if the borrower defaults on any other obligation.

By setting out such restrictions when launching a bond issue, borrowers find it much harder to use the money improperly.

“Junk bond issuers worry specifically about this sort of issue. And since SMEs are mostly family-owned, you want to know the family won’t raise money just so they can spend on outside investments such as real estate or other parts of the family business,” says Moody’s Chung.

Unfortunately such covenants appear unlikely, at least initially. “It’s more likely that [the CSRC] won’t introduce this formally and will leave it up to potential issuers to decide what kind of structures they will use,” says one securities source.

Companies should also be legally compelled to disclose any major corporate or credit events – typically the breaching of covenants. Covenants would be no use if a borrower simply avoided informing its investors, trustees or the regulators that it had breached them. Such events might include a company deciding to make an acquisition, a liquidity crisis, or a change in senior management or ownership.

Importance of trustees

Equally vital is a trustee system.

Independent trustees are responsible for the registration and transfer of bond payments between the issuer and the bondholders. They ideally act as a reliable party that oversees prompt coupon payments and protects bondholders’ interests in the event of default.

Investors need to know they can form an investor meeting to take action against the issuer if necessary, something trustees can manage. Given the size and diversity of a bond investor base, that typically requires a single entity to represent the whole bondholder base.

China has what Moody’s Chung calls a loosely defined “trust system” in place. There are bond trustees that monitor the progress of bonds and ensure money goes into the right accounts at the right time. Theoretically they can also get investors together if something goes wrong. But the latter point hasn’t been tested yet because there haven’t been any real defaults.

Additionally, the trustees of commercial paper issues in China tend to be the deal underwriters. As such they are far from independent, given their desire to sell the bonds and get fees for doing so. Added to that Nafmii hasn’t laid out any concrete laws governing the role of trustees in the interbank market.

Both Nafmii and the CSRC should insist that trustees are completely independent third parties that operate under a set of firm and explicit rules. While HSBC or State Street would typically act in this role internationally, in China trustees could be better-run commercial banks such as China Merchants Bank, or trust companies such as Guoyan Trust, Shanghai International Trust or Jiangsu Trust, or even law firms.

Chung notes that such trustees could be empowered to check weekly whether the borrower is complying with the bond covenants.

“So long as they don’t underwrite or trade junk bonds, they would be in a good position to act as a trustee,” he says. “The trustee must be independent of the transaction and be professionally capable in order to do their job properly. That would give investors faith in the bonds.”

However this depends on the trustees never underwriting or trading bonds, which may well take most commercial banks out of the equation.

Rule of law

These are all important steps, but they ultimately all depend on a visible approach to handling debt defaults and bankruptcy.

Defaults in a junk bond market are inevitable. So making clear what happens next is vital to foster investor enthusiasm.

If companies breach their covenants, or otherwise fall into debt delinquency, then investors need to know exactly how to go to the regulators or to court with the confidence that they will get at least some of their money back.

This is essential, particularly if Beijing wants to encourage more than just banks to buy this debt. To flourish, a high yield bond market will require the participation of private fund managers, hedge funds and high net worth individuals. But many such investors will be reluctant to buy the bonds of risky companies that can delay debt repayments yet not be declared in default.

These are all points that Beijing can resolve, if it has enough will. Optimists hope that it will do so, noting that recently installed CSRC head Guo Shuqing appears welcoming of financial innovation.

The high yield bond market concept is likely either his idea or has had his blessing and he will want to ensure its success.

But more must be done, and clarified, before Beijing opens the doors on this budding new market, or it may ruin a promising source of funds for SMEs for years to come.

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