China Defaults Sow Property Cash Crunch Concern: Distressed Debt

The specter of default in China’s trust loans market is deepening the distress of property developers that also borrowed in dollars.

Eighteen companies owing $15.2 billion, from behemoth China Vanke Co. to junk-rated Glorious Property Holdings Ltd., have “material exposure” in excess of 10 percent to trust financing, a form of non-bank lending that’s helped homebuilders proliferate in China, Moody’s Investors Service said. This year alone, the number of Chinese junk developer bonds whose yields have increased to distressed levels has almost doubled to 19.

Part of China’s $7.5 trillion shadow-banking system, trust financing has been key to fueling the nation’s 10 percent annual growth rate in the past decade by providing easy credit to companies considered too risky by banks. After trust loans to the property, solar, coal and other industries tripled in the past three years to 10.9 trillion yuan ($1.8 trillion), bondholders are becoming increasingly alarmed as the government reins in lending, housing demand cools and the economy slows.

“There’s concern China’s hitting a rough patch and that a few core industries, especially those based on credit such as real estate, may have peaked,” David Tawil, co-founder of the New York-based hedge fund Maglan Capital LP, said in a telephone interview. “The real question is whether Beijing will try to mask the down cycle or allow it to play out publicly.”

Defaults Unavoidable

Cracks are already starting to appear. Closely held Zhejiang Xingrun Real Estate Co. collapsed earlier this month, less than two weeks after Shanghai Chaori Solar Energy Science & Technology Co. defaulted on its debt.

While China Credit Trust Co. was bailed out in January, Premier Li Keqiang has said some defaults may be unavoidable as the government shifts policy to tighten credit.

Home prices have soared 60 percent since the government provided 4 trillion yuan of fiscal stimulus in 2008 to bolster the economy after the financial crisis, prompting companies to borrow heavily to speed construction. Now, as China abstains from providing further stimulus for the economy, thousands of apartment buildings across the country sit empty.

“If onshore defaults increase, it’ll definitely tighten liquidity and raise funding costs,” said Singapore-based Leong Wai Hoong, a high-yield bond manager at Nikko Asset Management Co., which oversees some $161 billion.

Funding Alternative

Trust financing involves the sale of high-yield investment plans to individuals, raising money for companies which may lack access to bank loans. According to Moody’s, it has become a key alternative of funding for land acquisitions by riskier real-estate companies during times they aren’t able to obtain reliable access to bank loans or the bond market.

Hopson Development Holdings Ltd. and Glorious Property, with a combined $1.3 billion of outstanding dollar-denominated bonds, are two which will face “inadequate liquidity” in the next 12 months if financing avenues seize up, Moody’s said.

Hopson’s $300 million of notes due January 2018, which traded at about 100 cents on the dollar at the start of the year, were at 91.47 cents today, according to prices compiled by Bloomberg. That’s pushed yields on the bonds to 12.8 percent, or 11 percentage points above Treasuries, more than the 10 percentage point threshold at which debentures are considered distressed.

Glorious’s $400 million of March 2018 securities fell to 72.08 cents on the dollar from 83.6 cents to yield 24.8 percent.

Hopson Loans

Hopson has about 2 billion yuan of trust loans and remains prudent in its borrowing strategy, Chief Financial Officer Xie Bao Xin said at a media briefing in Hong Kong on March 27. It plans to fully repay the trust loans in 2014, Xie said. Glorious didn’t reply to an e-mail request for comment.

Property developers account for 19 of the 22 junk-rated corporate bonds in China considered distressed as of March 28, according to a Bank of America Merrill Lynch index of high-yield notes from the country’s issuers. On average, investors demanded 7.98 percentage points of extra yield over similar-maturity Treasuries to hold the 105 securities included in the index.

Chinese junk bonds have lost 0.9 percent this year, versus a 2.9 percent gain for U.S. speculative-grade debt.

As a result of the building binge, the average debt ratio among the top 500 developers rose to a five-year high in 2013, the China Real Estate Association said in an e-mailed report March 20. The ratio of cash flow to short-term liabilities -- a measure of the ability to pay debt -- was minus 5.7 percent compared to 15 percent in 2012, according to the report.

Front End

Such leverage will put developers at the front end of the default cycle in a market shakeout, said Lisa Emsbo-Mattingly, the Boston-based director of asset allocation research at Fidelity Investments, which manages about $2 trillion.

While borrowing costs for China’s property developers have surged in the dollar-bond market, it’s unlikely the biggest real-estate companies will default any time soon, Nikko Asset Management’s Leong said.

“Dollar debt issuers are much larger and a lot of them have sold bonds to refinance their onshore loans,” he said. “Will those developers default? Not in the near term.”

Slower new-home price growth is nevertheless adding to the pressure on builders. Prices in first-tier cities such as Beijing and Shanghai grew in February by the slowest since 2012. At least 10 cities have moved to cool the housing market since November, including raising the minimum down payment on purchases. In smaller cities, companies such as Agile Property Holdings Ltd. have cut prices by as much as 20 percent.

Minsky Moment

Some 634 billion yuan of trust loans to developers must be repaid this year, an amount about the same size as Puerto Rico’s economy, Li Ning, a Shanghai-based analyst at Haitong Securities Co., China’s second-largest brokerage, said by telephone on March 26. That’s a 50 percent increase from 2013.

There’s a “high probability” some trust loans to property companies will default this year, according to David Cui, China strategist at Bank of America Corp.

Developers in mainland China or Hong Kong have also accounted for 32 percent of the $68 billion of dollar bonds issued by all Chinese companies last year. Chinese companies have more than $120 billion of notes and dollar loans due this year and next, according to data compiled by Bloomberg.

Since China’s credit crunch in June when money-market rates surged past 12 percent, both Societe Generale SA and Morgan Stanley have said a “Minsky moment” may be approaching, a reference to U.S. economist Hyman Minsky, who argued periods of rising asset values lead to speculative investments on borrowed money, only to end badly.

Chaori Solar missed payment on part of a bond coupon on March 7 in China’s first onshore default. Zhejiang Xingrun’s collapse followed on March 17. China narrowly averted its biggest trust default in at least a decade in January, when China Credit Trust repaid investors in a 3 billion yuan high-yield product after a bailout offer by Industrial & Commercial Bank of China Ltd.

“Many more defaults will definitely come,” said Bank of America’s Cui.

— With assistance by David Yong, and Judy Chen

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