China distress investing

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For all the media ink spilled, including by Reuters’ excellent Asia fixed income correspondent Umesh Desai, you’d think the ongoing fight in Hong Kong between severely-troubled Chinese real estate developer Kaisa Group and its creditors was the biggest, nastiest, most portentous blood feud the capital markets have ever seen. It’s none of that. It’s a reasonably small deal ($2.5 billion in total Hong Kong bond debt that may prove worthless) involving a Chinese company of no great significance and a group of unnamed bond-holders who are screaming bloody murder about being asked to take a 50% haircut on the face value of the bonds. The creditors have brought in high-priced legal talent to argue their case, both in court and in the media. Me thinks they doth protest too much.

Nothing wrong with creditors fighting to get back all the money they loaned and interest they were promised. But, what goes unspoken in this whole dispute is the core question of what in heaven’s name were bond investors thinking when they bought these bonds to begin with. Kaisa was, if not a train wreck waiting to happen, then clearly the kind of borrower that should be made to pay interest rates sufficiently high to compensate investors for the manifold risks. Instead, just the opposite went down. The six different Kaisa bond issues were sold without problem by Hong Kong-based global securities houses including Citigroup, Credit Suisse and UBS to some of the world’s most sophisticated investors including Fidelity and Blackrock by offering average interest rates of around 8%. If Kaisa were trying to raise loans on its home territory in China, rather than Hong Kong, there is likely no way anyone would have loaned such sums to them, with the conditions attached, for anything less than 16%-20% a year, probably even higher. Kaisa’s Hong Kong bonds were entirely mispriced at their offering.

It may strain mercy, therefore, to feel much sympathy for investors who lose money on this deal. Start with the fact Kaisa, based where I am in Shenzhen, is a PRC company that sought a stock market listing and issued debt in Hong Kong, rather than at home. Not always, but often, this is itself a big red flag. Hong Kong’s stock exchange had laxer listing rules than those on the mainland. As a result, a significant number of PRC companies that would never get approval to IPO in China because of dodgy finances and laughable corporate governance managed to go public in Hong Kong. Kaisa looks like one of these. It has a corporate structure, which since 2009 has been basically illegal, that used to allow PRC companies to slip an offshore holding company at the top of its capital structure.

The bigger issue, though, was that bond buyers clearly didn’t understand, or price in, the now-obvious-to-all fact that offshore creditors (meaning anyone holding the Hong Kong issued debt of a PRC domestic company) would get treated less generously in a default situation than creditors in the PRC itself. The collateral is basically all in China. Hong Kong debt holders are effectively junior to Chinese secured creditors. True to form, in the Kaisa case, the domestic creditors, including Chinese banks, are likely to get a better deal in Kaisa’s restructuring than the folks in Hong Kong.

This fact alone should have mandated Kaisa would need to promise much sweeter returns and more protections to Hong Kong investors in order to get the $2.5 billion. Investors piled in all the same, and are now enraged to discover that the IOUs and collateral aren’t worth nearly as much as they expected. Kaisa bonds were, in effect, junk sold successfully as something close to investment grade. As long as the company didn’t pull a fast one with its disclosure – an issue still in dispute – it’s fair to conclude that bond-buyers really have no one to blame but themselves.

At this point, it’s probable many of the original owners of the Kaisa bonds, including Fidelity and Blackrock, have sold their Kaisa bonds at a loss. Kaisa’s bonds are trading now at about half their face value, suggesting that for all the creditors’ grousing, they will end up swallowing the restructuring terms put forward by Kaisa. If the creditors don’t agree, well then the whole thing will head to court in Hong Kong. If that happens, Kaisa has threatened to default, which would probably leave these Hong Kong bondholders with little or nothing. Indeed, Deloitte Touche Tohmatsu has calculated that offshore creditors in a liquidation would receive just 2.4% of what they are owed. The collateral Kaisa pledged in Hong Kong may be worth more than the paper it was printed on, but not much.

The real story here is the systematic mispricing of PRC company debt issued in Hong Kong. It’s still possible, believe it or not, for other Chinese property developers with similar structure and offering similar protections as Kaisa to sell bonds bearing interest rates of under 9%. Meantime, as discussed here, Chinese property companies in some trouble but not lucky enough to have a holding company outside China are now forced to borrow from Chinese investors, both individuals and institutions,  at 2%-3% a month.

It’s a situation rarely seen – investors in a foreign domain provide money much more cheaply against shakier collateral than the locals will. Kaisa’s current woes are part-and-parcel of at least some of the real estate development industry in China. It seems to have engaged in corrupt practices to acquire land at concessionary prices. Kaisa got punished by the Shenzhen government. It was forbidden to sell newly-built apartment units in Shenzhen. No sales means no cash flow which means no money to pay debt-holders. Kaisa is far from the first Chinese real estate developer to run into problems like this. And yet, again, none of this, the “politico-existential” risk many real estate development companies face in China, seems to have made much of an imprint on the minds of international investors who lined up to buy the 8% bonds originally. After all, the interest rate on offer from Kaisa was a few points higher than for bonds issued by Hong Kong’s own property developers.

Global institutional investors like Blackrock and Fidelity might control more capital and have far more experience pricing debt than Chinese ones. But, in this case at least, they showed they are far more willing to be taken for a ride than those on the mainland.

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