High-Yield Debt: Asia’s New Bubble?

A worker changes the price board at a gas station of Sinopec in Yichang in central China's Hubei province.

What do we make of the frenzy in Asia’s debt capital markets? In a span of five days last month, a staggering US$8 billion was raised in Asia ex-Japan. In the week that followed, Sinopec (SNP), China’s state-owned oil company, issued the largest bond in Asia in a decade — worth US$3.5 billion. As of mid-April, Chinese debt capital markets deals reached US$129.7 billion, up 34% from the same period last year, according to data provider Dealogic.

No wonder it’s hard to get hold of investment bankers in Hong Kong these days: They’ve never been so busy.

Debt is back with a vengeance — thanks to record-low interest rates and excess liquidity. Nowhere is that more apparent than in Asia’s high-yield debt market. As of mid-April, Asian high-yield issuances have reached US$18 billion, already exceeding the total for the full year of 2010. Foreign investors are piling on Asian high-yield debt to escape near zero interest rates in Europe, the United States, and Japan.

Among the eager high-yield issuers are Chinese property developers. For example, Kaisa Group Holdings (1638:HK) raised more than US$1 billion so far this year via a US$500 million seven-year bond at 10.25% in January, a US$550 million three-year bond at 8.875% in March, and a RMB1.8 billion five-year dimsum bond at 6.875% in April. Kaisa’s March bonds reportedly attracted US$10 billion in orders despite a slowing Chinese property sector, and a quarter of the debt went to US investors. Longfor Properties (960:HK) issued two bonds worth US$900 million in total in a span of less than four months. The highest yield being offered by an Asian issuer so far this year is Xinyuan Real Estate’s 13.25% coupon on its five-year US$200 million bond.

Demand for high yield is not only coming from institutions but retail investors as well. In Hong Kong, high-yield bond funds had an average monthly net inflow of US$600 million from May to November last year, according to the Hong Kong Investment Funds Association.

Aside from bonds, innovative bankers are also enticing investors with high-yield structured products. For example, Chinese banks had US$1.14 trillion — roughly the size of Mexico’s annual GDP — in outstanding “wealth management” products as of end of 2012. Wealth management products are bundled assets similar to collaterized debt obligations that are often marketed as “safe” investments with guaranteed high returns. The products are supposed to provide liquidity to companies that are short on cash, but they have emerged to become, in the words of the chairman of Bank of China, “fundamentally a Ponzi scheme.” (Wealth management products form a fragment of China’s massive shadow banking sector.)

Is high-yield debt Asia’s new bubble?

The danger is that people are dazzled by eye-popping yields and due diligence will fall by the wayside. People need to pause and ask: What’s the catch? Why are issuers and banks offering much higher returns than others? Issuers and banks offer higher interest rates to compensate investors for higher risks, and investors should be aware what these are.

Investors need to stop being naive. For example, investors should scrutinize the finances of the debt issuers. What are the bonds for? Proceeds of Kaisa’s bonds were primarily used to refinance or prepay old debt. Longfor used its US$500 million 10-year bond in January primarily for refinancing, and Country Garden Holdings Company (2007:HK), another Chinese property issuer, used its US$750 million, also issued in January, mainly to redeem convertible bonds. In the above cases, only the remainder of the proceeds went into funding “existing and new property projects” and “general corporate purposes.”

Retail investors should receive proper risk education and should demand information on their investments from intermediaries. For example, if they are investing in a high-yield bond fund, they should know what bonds are in the portfolio and get an explanation on how bond prices and yields behave. Investors need to be proactive in seeking timely and relevant information about their investments. They can use the recently released CFA Institute Statement of Investor Rights as a guide for their conversation with financial services providers.

Moreover, institutional investors need to understand the structure and covenants of issuances. In the event of a default, the legal and regulatory environment for debt restructuring in Asia can be difficult and the enforcement of bankruptcy laws vary from country to country. Even if the borrower is listed in Hong Kong, which has Western-style laws, the law of another jurisdiction may still apply, depending on the fine print.

In the case of issuances by Chinese offshore holding companies, bondholders should be aware that they are often in a subordinated position and do not have any security over the assets of the onshore Chinese company. Therefore, recovery can be very difficult. The ongoing debt restructuring involving Chinese solar company Suntech Power Holdings (STP), a Cayman Islands–incorporated entity which defaulted on its convertible notes in March, is an example of the risks behind this type of structure. (In the case of Kaisa, Longfor, and Country Garden, the issuer is the Hong Kong–listed company, which is incorporated in the Caymans.)

Bondholders should also pay attention when issuers change the terms of covenants and demand adequate compensation. These changes may include removal of debt incurrence tests and lowered fixed charge coverage. Recently, some bondholders have accepted compensation without challenging the issuer’s motives or the long-term implications of those changes, which could include the deterioration of the issuer’s credit profile.

Lastly, investment banks also need to be conscientious about the issuers they bring to market. The pressure on Western investment banks to squeeze more profit out of Asia to offset weak business in the United States and Europe by promoting less-than-desirable issuers could backfire on the Asia’s nascent high-yield debt market and on the entire industry.

A vibrant Asian debt capital market is a highly welcome development, but we have to temper the euphoria with reality. Financial markets continue to be volatile. Although interest rates are expected to remain very low in the near future, we can’t discount wild cards that can negatively impact corporate earnings — for example, a severe bird flu outbreak and military confrontation over territorial disputes (i.e., between China and Japan, and China and Southeast Asian nations). The legal and regulatory environment can be thorny.

As former Citi CEO Charles Prince III said presciently in July 2007, a year before the global financial crisis, “When the music stops, in terms of liquidity, things could get complicated.”

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Photo credit: Associated Press/Liu Junfeng/ColorChinaPhoto

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