Bangkok--4 Mar--Fitch Ratings
Fitch Ratings has today commented that poor Chinese offshore bond documentation will continue to result in a deterioration of bondholders' relative position versus other lenders. This situation is exacerbated by weak corporate governance at Chinese privately-owned firms, which typically results in management decisions being taken primarily for the benefit of the majority shareholder, potentially at the expense of other capital providers.
In Fitch's view, investors in Chinese corporate offshore bonds should pay as much attention to structure and covenants, as they do to fundamental credit analysis, given the potential for their risk profile and level of recourse to worsen in a distress scenario. The inclusion of maintenance-based financial covenants that are tested regularly provides creditors with the ability to intervene and influence proceedings as and when an issuer's credit profile deteriorates. The benefit of stronger documentation, including maintenance-based covenants, was illustrated in the case of Nine Dragons' ('B'/Rating Watch Negative) recent prepayment of its syndicated loans. The company's deteriorating financial performance, reflecting a much weaker operating environment, resulted in the renegotiation of the financial covenants attached to its loans. Although both the syndicated lenders and the bondholders are theoretically ranked pari passu, the covenant renegotiation preceded a prepayment of approximately HKD1.5bn of outstanding principal - at par - to the syndicated lenders in December 2008, which compares extremely favourably with the 47% haircut the offshore bondholders have been asked to accept in the recent bond tender offer.
Moreover, the structural subordination of offshore lenders, typically located at parent/offshore intermediate holding company level without guarantees from onshore operating subsidiaries, also means that investors not accepting a bond buyback offer will typically find themselves even more subordinated than before. This is because the funding for any redemption of bondholders having accepted the buyback offer is likely to come from onshore sources, such as domestic banks lending directly at the operating subsidiary level. As a consequence, bond investors may find themselves compelled to accept an offer that they might otherwise have rejected, in order to prevent further deterioration of their position in the capital structure. In such cases where Fitch expects structural subordination to become significant, the agency notches the bond rating down from the Issuer Default Rating by up to three notches for speculative grade issuers.
However, Fitch notes that such structural subordination issues, albeit more severe in the case of Chinese offshore bonds, are not limited to PRC-based issuers. In the case of offshore bonds issued by Indonesian companies, the issuing entity is typically a special purpose vehicle, although bondholders do usually benefit from guarantees by the operating subsidiaries. Indonesian bond covenants, though viewed in general as weak, are - compared to Chinese bond covenants - tighter for some issuers, particularly for those with whom investors have suffered losses during the previous economic crisis; for example Ciliandra Perkasa ('BB-' (BB minus)/Stable). (For more information please refer to the report "Asian High Yield Covenants - How Effective Are They?" published in May 2007).
In more developed markets, where corporate governance tends to be stronger, management can be expected to treat bondholders more equitably in relation to other stakeholders in the interests of maintaining a longer term relationship with bond investors and thereby preserving its access to international bond markets in the future. However, in emerging markets such as China and Indonesia, privately-owned firms - often controlled by a single individual or family, and generally exhibiting poor corporate governance - typically adopt a more opportunistic approach geared towards maximising shareholder value in the short term, even at the expense of jeopardising their ability to issue offshore bonds in the future.
In the ongoing case of Asia Aluminium, the company's aggressive capital structure and continuing acquisition activity - as recently as November 2008 - have over-stretched its balance sheet and led to the current deeply discounted buyback offer. Under its proposed restructuring plan, the offshore bondholders are being asked to accept heavy losses in order to enable the company to secure new funding from Chinese domestic banks. While bondholders appear resistant to the offer at this time, it is a salutary lesson to the market that structural subordination and weak bond documentation leave bondholders at risk of such opportunistic initiatives by distressed issuers. As a consequence, when investing in bonds issued by Chinese companies, strong documentation giving bond investors some negotiating power in the case of deteriorating performance and reducing the risk of structural subordination by including - if at all possible - upstream guarantees from operating subsidiaries or limiting indebtedness at operating subsidiary level is all the more important.
A broader issue for the market is the potential damage that such buyback transactions could do to investor appetite over the longer term when Chinese High Yield issuers are again looking to access the offshore market. While this may not be an issue in the near term - as offshore markets remain stubbornly closed - the future healthy development of the Asian - and specifically the Chinese - High Yield market is dependent on investors becoming comfortable with the risks they are asked to take. Better documentation and creditor rights will be an important feature of this, but so will the confidence that issuers will treat them equitably in the event of a future distress or default scenario.
Contacts: Frederic Gits, Tokyo, +81 3 3288 2992/ [email protected]; Tony Stringer, Hong Kong, +852 2263 9559/ [email protected].
Media Relations: Nicole Batchelor, Singapore, Tel: +65 6796 7214, Email: [email protected].
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