Why Chinese developers' offshore bonds have dropped in price

Many developers are scrambling to avoid or delay a default by accelerating sales, extending their debts, making buybacks or borrowing from major shareholders.
Many developers are scrambling to avoid or delay a default by accelerating sales, extending their debts, making buybacks or borrowing from major shareholders.PHOTO: AFP

BEIJING (CAIXIN GLOBAL) - China's tightening of credit to the real estate sector and the debt crisis at China Evergrande Group have sent yields on the country's riskier notes to the highest level in a decade, making it hard for Chinese developers to borrow by selling offshore dollar bonds and threatening a wave of defaults.

This is not the first time Chinese property developers' offshore bonds faced a sell-off, but this time, the headwinds are particularly strong as investors are not only worried about losses on the bonds but also have started to question Chinese developers' overall credit.

Many analysts say they do not expect a policy easing soon. When the government might reverse its restrictive policy will depend on the scope of the sell-off of developers' dollar bonds and how much it affects the domestic bond market, said China economist Lu Ting at Nomura Holdings.

Still, officials including Vice-Premier Liu He, central bank governor Yi Gang and Mr Zou Lan, head of the central bank's financial market department, have made assurances that risks to the financial system stemming from Evergrande are controllable and are unlikely to spread.

Offshore bond sell-off

Evergrande - the world's most indebted developer with more than US$300 billion (S$403 billion) in liabilities - missed five earlier offshore bond payments in late September and early October, and has a further US$573 million coming due before the end of the year. That was followed with a surprise default by Fantasia Holdings Group and another missed payment by Sinic Holdings Group after a default warning.

Modern Land (China), a Beijing-headquartered developer with US$1.35 billion of dollar bonds outstanding, is asking holders for a three-month extension to pay off a note due on Oct 25. The company's US$200 million of dollar bonds due in February 2022 plunged to less than 32 cents on the dollar recently from 93 cents at the end of September. Shenzhen-based developer Kaisa Group Holdings' US$550 million of dollar bonds due in April 2022 declined to 52 cents on the dollar from 90 cents during the same period. Both companies had a B credit rating from Fitch Ratings.

Dollar bonds of at least a double-digit number of Chinese developers have plunged 20 per cent to 30 per cent recently. The yield on junk dollar bonds from the nation's borrowers, mostly developers, climbed to a decade-high of about 20 per cent this month.

Amid the rapid cooling of housing sales throughout the industry, the market is ignoring operating performance differences among issuers, and investors are dumping property companies' bonds as they cannot distinguish whether companies are already insolvent or simply have liquidity difficulties, according to a fixed-income analyst at a large brokerage.

Fantasia's default raises fears

A sharp drop in bond prices represents increasing market expectations that more real estate companies are at risk of default.

The Fantasia default on US$206 million of dollar bonds Oct 4 caught the market by surprise and caused the sell-off to intensify. Only two weeks before the default, the company said its operating condition were good, and it had sufficient working capital and no liquidity issues.

Four days after the default, Fantasia's founder and largest shareholder, Zeng Baobao, issued an internal letter to employees blaming a sudden significant downgrade by S&P Global Ratings for the company's tight liquidity. The company also said a change in the requirements by the local Shenzhen government on its banking account resulted in a delay in sales of its urban renovation project, affecting liquidity.

S&P cut the long-term credit rating of Fantasia from B to CCC on Sept 29. After the default, all three major credit rating companies cut Fantasia's rating to default or near-default status. Even though Fantasia is not a big developer in terms of sales, its default caused panic in the market. In the first nine months of this year, the company had sales of 40.87 billion yuan (S$8.62 billion), ranking 64th in the industry. Its default had a larger impact on confidence in the market, and investors are worried that other developers are under redemption pressure - but are still searching for solutions - will follow suit, a person at a Hong Kong hedge fund said.

Slow home sales

Many developers are scrambling to avoid or delay a default by accelerating sales, extending their debts, making buybacks or borrowing from major shareholders.

Since the implementation of the government's "three red lines" policy in August 2020, generating funds through home sales has become the priority for developers. The policy limits developers' ability to borrow based on their liabilities-to-assets ratio, net debt-to-equity ratio and cash-to-short-term debt ratio. But slowing home sales have made this approach difficult.

New home prices in 70 cities, excluding state-subsidised housing, slid 0.08 per cent in September from August, the first drop since April 2015, National Bureau of Statistics figures showed last Wednesday (Oct 20). Values in the secondary market declined 0.19 per cent, down for a second month.

Normally, developers sell homes to consumers before projects are completed. After the houses are sold, developers cannot get access to the funds until buyers' mortgage loans are approved. At the start of this year, it usually took about 50 days for banks to approve mortgage loans. Now the lending cycle can take two to three months or more, Caixin learnt.

Even after developers receive funds from sales, they can only use a portion of the money. The pre-sale funds, including down payments and mortgage loans, have to be deposited in a designated account regulated by relevant departments and financial institutions. Before the completion of the projects, some of these funds can be used only to pay construction costs and taxes and cannot be used for other purposes such as repaying debt.

Local governments usually require that 10 per cent to 15 per cent of the funds be retained in the special accounts. Lenders also require a certain proportion of the funds to be retained in the accounts in case of non-performing loans by developers.

Now many cities across the country are increasing supervision of such accounts. The supervision and requirements in each city are different, but it is estimated that developers can use only 30 per cent to 50 per cent of the funds in the accounts, an executive at a top 20 developer told Caixin.

Companies used to choose overseas refinancing to repay maturing debt. They usually plan half a year or even seven or eight months in advance to issue new offshore bonds. But now, the turmoil in the bond market has made it hard for Chinese developers to borrow abroad.

Even A-rated issuers now face difficulties in selling new dollar bonds, said an executive at a Hong Kong-listed Chinese developer.

International bond sales by Chinese developers have all but frozen up amid the Evergrande crisis. Since June, only one developer has managed to sell a bond this month, worth US$102 million. In the first three quarters of 2021, Chinese developers issued 40 dollar bonds worth US$9.1 billion, down 31 per cent from the same period last year, according to data from Dealogic.

A total of US$59 billion of offshore bonds by Chinese developers will come due in 2021, and US$61.5 billion is due in 2022, according to data from bond information website 97caijing. January, March, April and June of 2022 will be the peak months for debt repayment.

Chinese developers' dollar bonds used to be investor darlings as they offered high yields and had a relatively low default rate. Before 2021, only three developers had defaulted on an offshore bond: Kaisa Group in 2014, Mingfa Group International in 2018 and Tahoe Group in 2019, a senior Hong Kong bond investor said.

Bargain hunting

Even amid rising default risk, there are still investors hunting for bargains. Some investors are buying Evergrande's dollar bonds at the low prices because they think the company's assets will have value no matter how they are restructured, an Evergrande offshore creditor said.

These tend to be asset managers that invest in specific junk-rated bonds or distressed bonds, but all of the buy-side institutions now need to consider whether they will really have a say in restructuring payouts.

According to Bloomberg statistics, investors in Evergrande's dollar bonds include large international institutions - from asset management companies to government investment funds.

Six of the seven largest Asian high-yield bond funds have been offloading Evergrande's dollar bonds since May, cutting holdings to less than 1 per cent of their portfolios in August, down from as much as 3 per cent, according to Morningstar.

But as Evergrande and other Chinese developers are included in international high-yield bond indexes, funds tracking the indexes cannot sell their holdings as freely.

For creditors of Chinese developers, short-term financial pain in inevitable, but in the long run, foreign investors can still participate in China's high-yield and diversified bond market with the right research methods and selective deployment, said PineBridge Investments, a private global asset manager.

This story was originally published by Caixin Global.