As Pace of China’s Junk Bond Sales Grows, So Do Worries

HONG KONG â€" It has an all-too-familiar ring. Investors, in search of better rates, rush to risky, high-yield bonds, raising worries that the market is overheated.

But the concerns â€" which have already been voiced about the $120 billion of European and American junk bonds issued this year â€" are now being applied to the fledgling Chinese market.

While American and European companies have been selling high-yield debt for decades, Chinese businesses only recently started to tap into the junk bond market in earnest.

It’s a sign that the Chinese capital markets are growing up. As the country’s economy continues to open up, private sector businesses have looked to foreign investment to finance their expansions efforts, rather than relying on hard-to-get loans from the state-controlled banks.

The junk bond market in China took off this year. Although the deals still accounts for a small share of the global total, Chinese companies have sold $8 billion of high-yield bonds to overseas investors since January. That’s up from $2.3 billion during the same period a year earlier, according to figures from Dealogic.

“Bond markets are booming because companies have had difficulty getting the level of debt they want out of banks onshore or offshore, and in tapping equity markets,” said Nick Gronow, a senior managing director at FTI Consulting in Hong Kong and an expert in Chinese bankruptcies. “So bonds have really taken up the slack.”

But the pace of growth is troubling to some analysts.

As investors have plowed into junk bonds across the globe, yields have plummeted. In the United States, rates on junk bonds have dipped below 6 percent, compared with the historical payouts of roughly 10 percent or more.

The trend is similar in the China.

Country Garden, a builder based in the southern city of Guangzhou, raised $750 million in January by selling 10-year bonds that paid 7.5 percent a year. In 2011, the company sold $900 million of seven-year bonds at a much higher 11.125 percent.

The borrowing costs for Kaisa Group Holdings, a commercial real estate company in the southern city of Shenzhen, have also dropped rapidly. In September, it sold $250 million of five-year bonds at 12.875 percent. By January, it was able to sell $500 million of bonds at 10.25 percent. This month, it issued new bonds at 8.875 percent.

“Chinese real estate issuance is happening for structural reasons: 50 percent of the population needs to be urbanized and housed, traditional funding from banks may be more restricted now, and global appetite for yield is on the rise,” said Gregorio Saichin, the London-based head of emerging markets and high-yield, fixed-income portfolio management at Pioneer Investments. “When you combine all the above factors with a massive refinancing exercise by Chinese property developers, you get this type of outcome.”

But it’s a slim difference in yields for such disparate markets.

Chinese high-yield bonds have many of the same characteristics â€" and risks â€" as American debt. They tend to be sold by companies looking to finance ventures in new or untested areas or businesses that compete in industries where earnings are subject to volatile swings.

But the Chinese market has its own set of potential problems, and some analysts worry that investors aren’t being properly compensated for the added layer of risks.

For one, the bulk of the high-yield bonds in Asia this year â€" roughly half â€" come from Chinese real estate companies. The fear is that the housing market, which has been booming, is a bubble that will eventually burst.

The industry is especially uncertain, given the periodic government intervention. On March 1, Beijing announced new measures to curb excess in the market, including the strict enforcement of a 20 percent capital gains tax on the sale of preowned homes.

“With the new leadership in China, people are still not sure which way things will go in terms of property policies,” said Suanjin Tan, an Asia fixed-income portfolio manager based in Singapore at BlackRock. “That also adds to the desire among these guys to remain cashed up, so they can take advantage of any wobbles in the market to pick up land on the cheap.”

Chinese junk bonds also have a unique structure, which could leave investors vulnerable.

Mainland China’s domestic bond market remains largely off limits to foreign buyers. So most investors buy offshore Chinese bonds, which are issued through holding companies headquartered in places like the Cayman Islands.

The bonds tend not to be backed by the actual businesses and underlying assets in mainland China. That means foreign bondholders may have little legal recourse if a company defaults on its debt, especially if local banks or other Chinese creditors make claims.

Bondholders are now facing such difficulties with the bankruptcy of Suntech Power.

Earlier this month, Suntech, the world’s largest solar panel maker, stopped making payments on $541 million in convertible bonds largely held by foreign investors, including Pioneer Investments. On March 21, a court in Wuxi, a city in eastern China, accepted a bankruptcy petition filed by eight Chinese banks against Suntech’s main operating unit in China, a group that’s seeking to recoup some of the money it lent to the company.

If previous Chinese bankruptcies are any indicator, those local banks will take priority in the so-called liquidation process, while foreign bondholders may lose everything. “The greatest difficulty the bondholders have, when things go wrong, is what leverage do they actually have against the company” Mr. Gronow of FTI Consulting said.

The answer, usually, is not much. Mr. Gronow cites the case of Asia Aluminum, a manufacturer in the small southern city of Zhaoqing that collapsed in 2009 after accumulating more than $1.7 billion in debt.

After several months of often strained negotiations between the company, mainland and Hong Kong banks, foreign bondholders and the government, Mr. Gronow and his co-workers, acting as liquidators, worked out a deal that gave back Asia Aluminum’s bank creditors in Hong Kong 100 percent of their capital.

Others were not so lucky. The owners of bonds issued by one offshore subsidiary received about 20 cents on the dollar. And investors in riskier “payment-in-kind” notes, a sort of hybrid bond where interest payments can be made by selling more debt, received only about 1 cent on the dollar.

“The thing you face as a liquidator dealing with these situations is how to maximize the recovery,” Mr. Gronow said. “Clearly, getting that sort of return, they were not very happy about it.”