Default Mode: Chinese Corporate Bonds
In China, are keepwell agreements and other letters of support worth the paper they're written on? In light of the nation's most recent corporate default, this is a question dollar bond investors must be starting to ask themselves.
Shanshui Cement's inability to repay 2 billion yuan ($314 million) of notes triggered a cross-default on its offshore bonds. The $500 million of 7.5 percent securities due 2020 plunged 17.3 cents to a record-low 65 cents on the dollar Wednesday, making for one ugly graph:
Analysts at Mitsubishi UFJ Securities predict investors will recover as little as 40 cents on the dollar and there are some who say it could be a lot less than that. The debentures were sold only in March, at 98.98 cents.
Outside of insufficient funds, what prompted Shanshui to file a winding-up petition is anyone's guess. It certainly took the market by surprise because many had expected the company to redeem the bonds with the assistance of its major shareholders, Tianrui International, state-backed China National Building Material and Taiwan’s Asia Cement Corp. The latter two have been considering a possible takeover offer for months, but so far haven't tabled anything.
Largest shareholder Tianrui had also offered to help obtain additional financing, on condition it could appoint its own nominees to the Shanshui board. Shanshui asked Tianrui to provide a credible proposal by the close of business Monday. Presumably that didn't materialize, prompting speculation the move to have provisional liquidators appointed was an attempt by Shanshui to force Tianrui's hand. An extraordinary general meeting scheduled for Nov. 25 will vote on changing the composition of the board.
Whatever the reason, investors' expectations of shareholder assistance are fast unraveling. Although the 2020 bonds were sold with a letter of support from CNBM, page 18 of the sale prospectus states that doesn't ``represent a guarantee or a legally binding obligation of CNBM in relation to the notes.'' In fact, the letter was ``given by way of comfort only,'' it goes on to say.
This is worrying. The international investment community has given much truck to connections with Chinese state-owned entities. Ratings firms including Fitch have a policy (which some are reviewing) of ``notching up'' a company's credit score based on assumptions of state support. There are countless examples of companies or their bonds receiving elevated ratings because of sovereign ties.
What's more, it's alarming how many Chinese dollar bonds have been sold over the past few years with so-called keepwell agreements -- another type of not-legally-binding credit enhancement whereby the parent company of an issuer promises to maintain the borrower's solvency while stopping short of guaranteeing payment. From not being a thing a decade ago, some $17.3 billion were issued in 2014, rising to $20 billion this year, Bloomberg data show:
With defaults happening left, right and center in China these days, investors would do well to dust off bonds' original sale documents and read the fine print. Those letters of support may provide scant comfort once the crunch comes.
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