Chinese debt market fails to price risk

China is an intriguing place where private debt investment is possible. But there are risks associated with lending in the country and many global investors could be misjudging those in the race to find higher yields.

If creative enough, it is possible for foreign capital to successfully invest in Chinese debt, to paraphrase industry experts at PDI’s inaugural conference Corporate Debt in China, which took place in Hong Kong last week.

However, the risks are significant, and still unpriced, several delegates said.

Domestic issuers of and foreign investors are increasingly turning to high yield instruments such as the junk bond market and ‘trust’ loans. The high yield market in China, which operates through both onshore and offshore structures, is the fastest growing high yield market in the world, an industry expert told PDI, with more than 50 percent of issuance made by real estate companies, one of the more over-leveraged sectors in China.

It’s debateable whether returns in the market are commensurate with the risks, although moral hazard is not considered a factor at present with the Chinese government bailing out the three defaults that have occurred in the market so far this year.

Of particular importance to creditors will be how China addresses difficulties surrounding restructuring or enforcement, on which there has been some movement recently, delegates heard. “I’ve definitely seen huge steps forward,” Neil McDonald, partner at law firm Kirkland & Ellis, said. Overall though, questions of when or how fast these initiatives take effect remain.

Recoveries, in the event of default, can be difficult to achieve. In the case of a higher leverage loan, the employment of third party guarantors is typically used, delegates heard. The legal framework in which they operate is questionable, however.

Based on ‘structural subordination’, which offshore vehicles in particular operate on, the collateral backing these bonds can be deeply subordinated in nature and can severely limit access to the underlying assets of the business invested in when trouble hits: “The risk has been completely mis-priced by the market.. the high yield market is structurally very, very risky,” McDonald said.

McDonald opined that a “hands on” approach to debt would be the more successful debt investment strategy in the long run. “Once you have ‘the chops’ (official company documentation) you can control the business and that's the only way to enforce in China,” he said.

Reform rumours 

The Chinese government is ready to reform and lift limits on foreign debt investment into the country, some delegates suggested, particularly on a case-by-case basis. However, as with the announcement of other initiatives to rebalance the Chinese economy, implementation is a more drawn-out matter.

China’s growth is spectacular compared to more developed nations but as with the West’s experience in the early 2000s much of that growth has been fuelled by debt, albeit mainly domestic. Much of the lending has been in the real estate and infrastructure sectors with very little investment in operating companies, Darren Stone, vice president of AlixPartners, said in a presentation. Non-performing loans in China are reported to be around 1 percent but he estimated them to be around five to seven times that.

A huge mis-allocation of capital has taken place and it is unsustainable, many panellists across topics iterated. There is still a lot of room to grow in China but it needs to occur at a slower and “safer” pace. And reforms are paramount, all agreed.

Meanwhile, small- to medium-sized businesses in China are starved of capital, compounded by a mass withdrawal of foreign private equity funds in the last few years, many of which were burned in the difficult operating environment. ‘Shadow banking’ or alternative forms of lending from the banking sector have grown as a result of the vacuum.

The cost of capital in China is very high, according to Peter Fuhrman, chairman and chief executive of China First Capital. And the costs are “way beyond what companies elsewhere [in the world] pay,” he said. “Where that is true, there is opportunity,” he continued.