The recent stumble of Asia’s high-yield bond market has prompted me to revisit that issue which is always thorny when it comes to high-yield credit: cash leakage.
It’s a well-worn beginner’s lesson in both the bond and loan markets that you would rather lend to the operating company than the holding company. In the former case you are closer to the assets if things go wrong, while in the latter you can be lending to an entity which has no assets available to creditors in the event of a debt restructuring.
Cash leakage refers to the ability of company to upstream or downstream dividends to suit its best interests. And that got me thinking about the most recent high-yield deals to fall by the wayside.
China was the source of one of the three deals to be pulled the week before last, in the form of Lionbridge Capital, while the others came from India and Indonesia; these three countries are the most fecund source of high-yield primary debt in the Asian bond markets.
The background to the Lionbridge deal is noteworthy. Secondary had gone rather ugly on certain portions of the Chinese corporate offshore yield curve, with heavy selling seen on various bonds.
THIS MARKDOWN APPEARED at first glance to have come out of thin air, but on further inspection may have been based on reports of a major lending clampdown to some big Chinese conglomerates with high levels of offshore borrowing. Names mentioned as the targets of this clampdown included the HNA group, Dalian Wanda, Fosun International, insurer Anbang International and investment holding company Zhejiang Luosen.
Why were these names cherry-picked out of the substantial pile of Chinese entities which have creamed billions from the offshore bond and loan markets over the past decade?
One reason - as opposed to targeting names in the debt-heavy real estate sector - is that these companies had led the debt-fuelled outbound M&A charge from China last year to the tune of just north of US$100bn.
And the large Chinese banks did much of the lending - presumably looking for anything resembling a decent return on equity, in the face of contracting net interest margins at home.
In this context, the clampdown is slightly surprising, given that in their annual reports published this year, the big Chinese banks pointed to their willingness to continue to extend credit to existing big corporate clients, while indicating their reluctance to grow the loan book via new clientele. Instead, the focus was in most cases on growing the SME and micro-lending books.
According to these annual reports, the bad loan books at most of the big Chinese banks are manageable at an average 1.67% - a competitive level in international banking terms, if you consider that NPLs in the euro area peaked at 8% in 2013, but a high one in relation to delinquent loans in the Chinese banking system.
Meanwhile, the task the Chinese banks are trying to address is overcapacity and high leverage across a range of industries, both from the domestic and the offshore point of view.
In this task an obvious item hogging the limelight is outbound M&A lending, principally where the Chinese purchaser has over-estimated cashflow and there are struggles to service the debt.
This will leave domestic Chinese banks under pressure to roll over acquisition-related loans at a time when they are trying to rationalise their books. At the same time, foreign banks are growing wary of Chinese credit risk.
EVEN THOUGH MUCH of the foreign bank support for outbound M&A activity has been at the overseas opco level - and therefore appears to be removed from any tightening by the Chinese regulators - there remains the risk of cash leakage from opco to holdco as Chinese owners extract their dividends.
That leakage presents a stern test of corporate governance in China. And, given the recent low standards, I am worried about the risk of cash leakage in Chinese borrowing entities in the face of a looming crackdown from the financial authorities.
Of course, China’s government has the deep pockets and the political will to avoid a hard landing for its economy, which is the natural conclusion of stretched banks amid spiralling loan delinquency. It’s not quite the same situation as the banking crises we have seen over the past few decades in Europe, which have been largely left to market forces for resolution. In China, a regulatory cherry-picking exercise will continue to determine the winners and losers.
Offshore investors need to apply the same discipline when it comes to high-yield bonds: you need to cherry pick. And in that endeavour I would avoid buying the bonds of Chinese companies with substantial loans on the balance sheet, particularly from foreign banks.
A full-scale leakage of cash would step up the risk on any debt issued by these entities quite considerably, in my humble opinion.
