In this Q&A interview Lee discusses the risk investors buying offshore Chinese bonds face, explains the bonds ongoing popularity and offers his advice to potential buyers.
What lessons can be learned from the Sino Forest and Asia Aluminum cases?
Lee: I think the lessons learned are that structural subordination is a real issue and hinders the ability of bond holders to maximize recovery in a workout scenario. A lot of bond issuances by China-based companies, whose operations are in China, are issued using an offshore entity. Unfortunately, regulatory constraints limit the ability of bond holders to obtain credit support or security, such as upstream guarantees, from the operating subsidiaries in China holding the real assets.
In the eyes of some cynical commentators, bond holders of offshore entities basically rank the same as equity. So, some may say that they basically are buying equity but without the upside of equity. However, I think that despite the risk, there has been a great demand for these bonds because the quantitative easing and the recent doldrums in the equity markets have resulted in people chasing yield, driving the demand for these types of securities.
It is a difficult structure. If you look at the recovery rates for bonds in Sino Forest and Asia Aluminum, I don’t think bond holders got a good deal. If they had a better structure they probably would have had better recovery rates.
What advice would you give to those considering investing in offshore Chinese bonds? Is there a large amount of risk?
Lee: I think hopefully they will price in the risk. A lot of the recent demand is driven by high net worth individuals. If you look at how many of these bonds are sold, a large portion of them are sold through private banks to their clients. So, again it is basically driven by a chase for yield. Some of these bonds offer rates like 13 to 14 percent. The structural challenges are pretty hard to overcome because they are based on regulatory constraints, so I think people should invest in them knowing the risk and hopefully the yield is sufficient to compensate for that higher risk.
In most European restructurings, the operating companies do not file for formal insolvency and all the financial restructuring is done at the level of the holding company who holds the debt. In one of the recent Chinese restructurings, the principal Chinese operating subsidiary of Suntech, which defaulted on an offshore bond payment, filed for bankruptcy in Chinese courts. This only brings additional uncertainty to the process in addition to the structural subordination issue.
Does Chinese law offer any protection for offshore bond holders in the case of a bankruptcy?
Lee: Chinese law has a similar regime to the United States — China also has a similar chapter 11 protection. But, as I said, because of structural subordination the bondholders are not direct creditors of Chinese companies. So, effectively if something were to happen to the offshore entity the bond holders would basically be treated as equity holders of the offshore entity, effectively ranking at the bottom of the capital structure of the Chinese companies. Furthermore, although China has a chapter 11-like procedure, Chinese courts will likely apply it in a different manner and so distressed investors should not assume that they will get the same outcome as they would in the United States. We are not aware of any Chinese precedent, and as Chinese courts are not used to the new procedure, it is difficult to predict the outcome, implementation or timing.
Are there any new developments or structural changes in Chinese bonds?
Lee: The recent development is that some people are trying to get some form of credit enhancements from onshore entities. These are used primarily in transactions involving large China-incorporated parents issuing offshore bonds through overseas subsidiaries. The form of credit support, such as a keepwell deed, is short of a guarantee. Unfortunately, these types of credit enhancement have not been tested and are not foolproof. You even see risk factors in the offering documents warning that they might not be enforceable. This area is still evolving and we’re continuing to see market innovation. Having said that, we rarely see the structure used in the bond transactions involving China-based issuers who are actually the offshore listed parents.