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Accounting `Red Flags' Drive Bond Spreads to Record Levels: China Credit

Borrowing costs have risen to record levels for Chinese companies marked with “red flags” by ratings firms for unclear financial reporting and high levels of private ownership.

The extra yield investors demand to own the bonds of Nine Dragons Paper Holdings Ltd. (2689), LDK Solar Co. and Road King Infrastructure Ltd. (1098) instead of similar-maturity government debt widened to all-time highs after they were named by Fitch Ratings or Moody’s Investors Service for issues such as having changeable profit margins or long-serving independent directors.

The bookkeeping of Chinese corporations has come under scrutiny after short sellers said companies from Longtop Financial Technologies Ltd. to Sino-Forest Corp. (TRE) were overstating profit margins or exaggerating asset holdings. Spreads on the nation’s company bonds widened 23 basis points this year to 146 basis points, compared with a two basis-point advance for company debt in the U.S., Bank of America Merrill Lynch indexes show.

“No one knows everything about what’s really going on at some of these companies,” said Scott Bennett, Aberdeen Asset Management Asia Ltd.’s Singapore-based regional head of credit. “You have to give these borrowers some benefit of the doubt and then draw comfort from China’s strong economic backdrop.”

Central bank policies to curb inflation in an economy that grew 9.5 percent in the second quarter from a year earlier are making it harder to borrow, increasing the risk Chinese companies may default.

Red Flags

Moody’s warned of red flags at all 61 companies it examined in a report last week, highlighting risky or opaque business models, poor quality earnings and cash flow, and concern that the quality of financial statements is not good enough. Fitch said yesterday about 35 Chinese companies may find capital markets closed to them due to escalating corporate governance concerns.

“International investor interest in Chinese companies, driven by high levels of growth and the search for yield, is coinciding with limited access to information at key issuing entities,” said John Hatton, Asia-Pacific corporates group credit officer at Fitch. Companies with a “blemished reputation” can’t raise funds, especially if there’s an accompanying deterioration in investor sentiment.

When reviewing a company’s corporate governance practices, investors should be alert to concentrated private ownership and independent directors staying on boards for longer than five years, Fitch said in its July 18 report.

Nine Dragons

Nine Dragons, a paper products company with four factories in mainland China, has had the same group of independent directors serving on its board since 2006, Fitch said. Chairwoman Zhang Yin, China’s richest woman, boosted her stake in the company last month. Standard & Poor’s also withdrew the company’s debt ratings in June.

Nine Dragon’s debt level will peak this year, Zhang said on June 27 after the company’s shareholders meeting that day.

The company’s 9.875 percent notes due April 2013 yield a record 11.13 percentage points over similar-maturity government debt, from 10.12 percentage points at the start of the year, Royal Bank of Scotland Group Plc prices show. Nine Dragons hasn’t decided yet whether to comment on the Fitch report, according to Wonderful Sky Public Relations & Financial Consultant Co., which handles its media relations.

The yield premium on LDK Solar’s 10 percent, three-year bonds has risen 221 basis points, or 2.21 percentage points, since their sale in February to a record 10.18 percentage points, RBS prices show. The company makes solar cells and was singled out by Fitch for its volatile profit margins and long- serving independent directors.

Director Resigns

LDK Solar, based in Jiangxi province in the middle of China, said yesterday independent director and the chairman of its audit committee, Louis Tung-jung Hsieh, had resigned and will be replaced on the board by Maurice Wai-fung Ngai, founder and managing director of corporate service company MNCOR Consulting Ltd., according to a statement issued late yesterday by PR Newswire. Bing Xiang, another director, will head the audit committee temporarily, the statement said.

Calls to the U.S. investor relations telephone number listed on LDK Solar’s website weren’t immediately answered outside of normal business hours.

The spread on Road King’s 9.5 percent, five-year notes sold in September has risen to a record 945 basis points, an increase of 183 basis points since January, BNP Paribas SA prices show. Arien Sy, Road King’s investor relations manager, said it wasn’t fair to compare the Hong Kong-based company, which has a “long established history,” to companies on the mainland which are “relatively new to the listing standard.”

Smaller Returns

Road King, which is also Hong Kong-listed, has its core business in the “investment, development, operation and management of toll roads and property projects” in mainland China, according to its website.

Company bonds in China have returned 0.05 percent this month, compared with gains of 1.2 percent on U.S. corporate debt and 1.1 percent on company notes sold globally, Bank of America Merrill Lynch indexes show.

Local currency bonds in China have gained 1.3 percent since January compared with returns of 2.5 percent, 5.4 percent and 10 percent for local currency debt in India, Russia and Brazil respectively, JPMorgan Chase & Co. indexes show.

“One of the unusual things about China is that you have a very high-rated sovereign with very bad systemic issues in terms of clarity of regulation, rule of law and transparency of information,” Andrew Steel, Fitch’s Singapore-based head of corporate ratings, told Bloomberg Television yesterday. “There’s a huge differential between the strength of the state and the environment in which companies are operating and that tends to make investors less cautious than they ought to be.”

‘Too Negative’

China is rated A+ by Fitch, its fifth-highest investment grade. The cost to insure government debt against default has risen 25 basis points this year to 92.2 basis points, according to data provider CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market.

Corporate governance practices have improved in China from five years ago, according to Andrew Mattock, a Singapore-based fund manager at Henderson Global Investors Ltd., which had 76.2 billion pounds ($122.5 billion) of assets under management as of the end of March.

“Obviously there are going to be scattered cases of corporate governance issues, but that shouldn’t surprise any seasoned investor in Asia,” he said. “Listing rules have got better and investor relations have got better. People are plain too negative on the issue.”

Rate Rises

Credit-default swaps on Brazil have risen nine basis points to 119.6 this year, while those for Russia increased 9.5 to 156. Contracts on State Bank of India, seen as a proxy for the nation, rose 47 basis points to 208.2 in 2011.

The People’s Bank of China raised rates three times this year to cool inflation and ordered lenders to increase the level of reserves they set aside six times. China’s inflation hit a three-year high of 6.4 percent in June and has breached the government’s 4 percent ceiling every month this year.

“There’s no hint at all of any letup in tightening, in fact, we see it accelerating,” said Paul Schulte, Hong Kong- based global head of financial strategy at CCB International Securities Ltd., a unit of China’s second-largest bank. “Inflation is too high, the currency is too strong and growth is too strong, still.”

The three-month Shanghai Interbank Offered Rate was 5.981 percent as of 2:20 p.m. in Singapore, down from a record 6.46 percent on June 28.

Weakening Yuan

China’s seven-day repurchase rate, a gauge of the availability of funds in the financial system, has almost halved to 4.6227 percent since hitting a three-year high of 9.04 percent on June 23. The yuan was little changed at 6.4688 per dollar at 3 p.m. in Shanghai today, according to the China Foreign Exchange Trade System. The currency touched 6.4563 on July 14, the strongest level since China unified official and market exchange rates at the end of 1993.

The yield on China’s benchmark five-year government bonds rose five basis points to 3.6502 percent yesterday, the biggest jump since June 22, according to National Interbank Funding Center data.

The “preponderance” of new issues by Chinese industrial companies has also pushed spreads wider, said Aberdeen’s Bennett, who manages Asian credit portfolios worth about $1.5 billion.

Chinese developers have sold $10.2 billion of dollar bonds alone in the past 12 months, compared with $1.6 billion for real estate companies in the rest of Asia, according to data compiled by Bloomberg.

Aberdeen is sticking with higher quality issuers and those with a good payment track record, Bennett said.

“With fraud as a constant risk, there’s not much else we can rely upon except that these companies paid their debt obligations last time,” he said.

To contact the reporter on this story: Katrina Nicholas in Singapore at knicholas2@bloomberg.net

To contact the editor responsible for this story: Shelley Smith at ssmith118@bloomberg.net

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