China bondholders call for global standards

IFR 2025 22 March to 28 March 2014
6 min read
, Ken Wang

Investors in China’s domestic bond market are seeking greater protection, after this month’s unprecedented bond default forced a reassessment of credit risks.

Shanghai Chaori Solar Energy Science & Technology’s missed coupon payment on March 7 has triggered calls for better credit-hedging tools and stronger covenants – global standards that have been long overlooked in China.

“There are no covenants for onshore bonds and Chinese investors are unfamiliar with covenants,” said Ivan Chung, senior credit officer at Moody’s. “There is no legal framework in China to protect bondholders and market participants overlooked covenants until there was a default.”

Domestic bonds offer few ways for investors to enforce their claims against a company, and investors are now becoming more interested in external credit enhancement for high-yield issuers, according to one fund manager. Credit default hedging tools, however, remained underdeveloped in China relative to the rest of the world, she said.

Until the Chaori default, Chinese investors had assumed an implicit state guarantee meant that bondholders would be paid in full, and this was the reason few cared about bond covenants, said Kalai Pillay, a senior director at Fitch.

Typical covenants in the Reg S or 144A markets impose restrictions on cash leakage, related-party transactions, risky investments, additional leverage, structural subordination and changes of ownership.

The absence of cross-default clauses, designed to ensure equal treatment by allowing creditors to accelerate repayment if a borrower falls behind on any of its liabilities, is perhaps the most striking omission.

“There is no legal framework in China to protect bondholders and market participants overlooked covenants until there was a default”

That absence has helped bondholders in China in the past, with countless examples of companies redeeming their bonds despite falling behind on bank loans, but in the case of Chaori a lack of that particular clause left bondholders at a serious disadvantage.

The Shenzhen-listed solar cell maker fell behind on its bank loans over a year ago, but bondholders were unable to take any action either to call for accelerated repayment or to restructure their bonds until the end of a grace period for the March 7 coupon payment.

As a result, while bondholders waited for the inevitable to happen to their bonds, bank creditors were already working to recover their money.

The absence of cross-default clauses in Chaori’s debt is worse news for the company’s trust lenders. The loss-making company has five outstanding trust loans, totalling Rmb250m, that are officially still current, according to analysts. They will come due in the second half of this year, meaning trust loan holders cannot act now to fight for Chaori assets.

The lack of investor protection in Chaori’s debt is far from unique. Shanghai-listed Baoding Tianwei Baodian Electric, for example, has defaulted on its bank loans, but has continued to pay bond coupons, leaving bondholders unable to accelerate payment of principal.

“[The] cross-default clause is one of the most basic covenants for Reg S or 144A bonds – it is intended to protect bondholders before the company defaults, but it is almost non-existent in Chinese onshore bonds,” Chung said.

The Chaori default may provide a catalyst to encourage regulators to push through reforms in the world’s third-largest bond market, sources said, although any changes will only take place over several years.

Issuers, especially private-sector companies, may also find it beneficial to offer some covenants in future offerings in order to attract investors in the current tight liquidity conditions in China. “It could turn into a buyers’ market from a sellers’ market,” Chung said.

More coming?

Meanwhile, fears of further defaults in China’s domestic bond market are pushing up yields on stressed assets as analysts and investors race to identify the next company heading for trouble.

In a recent report, CICC produced a watch-list of 24 bonds from 19 issuers that recorded losses in 2012 and most of 2013. Trading in some of these bonds has already been suspended. Some analysts suggested bonds from companies in sectors facing excess capacity, such as solar energy, iron and steel and shipping, might be at most risk.

As a result, China’s domestic traders are scouring financial statements and have started to shun bonds they deem most likely to default.

At the end of February (before Chaori said it would miss its coupon payment), only one bond traded at a yield high enough to reflect the risk of default: Sinovel 2011-01 was quoted to yield 22.30% at the time. By March 14, however, the yield had surged to 29.61%, while Zhuhai Zhong Fu’s 2012-01 was yielding 27.45%, ZhongFu Industrial’s 2011 was yielding 20.41% and Xiang E Qing’s 2011 was yielding 21.82%.

Bond yields may not tell the full story, however, since trading in a bond is usually stopped after a company posts losses for two consecutive years. At the same time, investors have shifted to safe-haven bonds issued by state-owned enterprises and other municipal-supported bonds, according to one trader. Yields on SOE Beijing Energy’s 2012-01s narrowed to 5.25% on March 14 from 5.48% at the end of February.

Not only bonds

Trouble may also crop up in related financial markets, as some weaker companies have turned to bank loans and trust products for financing, instead of the domestic bond markets.

According to Citic Securities, there are 7,966 trust products totalling about Rmb1trn (including interest payments), due this year. About Rmb248bn of these trusts were created to finance property companies, where slowing property sales have raised fears of a funding crisis.

China