The end of the beginning is at hand for China developer defaults. In the first stage, firms asked investors to exchange or extend defaulted bonds, to buy some time until the property market recovers. In the next stage, we assume investors will lose patience for such deferrals, especially if home sales do not soon recover. S&P Global Ratings believes that developers' liquidity risk will evolve into insolvency risk if the sales recovery stalls. We assume debt extensions only serve to buy time, and do not fundamentally resolve developers' excess leverage.

Based on our sensitivity tests, at least one-fifth of rated developers could be insolvent. This assumes no refinancing, and that all pre-sold obligations are completed. We assume further that one-third of minority interests are repaid and all existing debt is settled using internal cash and cash generated from property sales and asset sales (see "China's Property Downcycle Won't End With Policy Easing," April 6, 2022).

At stake is about US$88 billion in distressed bonds issued by China developers. Developers have over the past 12 months completed exchanges or extensions on about US$27.8 billion for distressed bonds. This was a useful step while creditors took a moment to assess a fast-breaking downturn in China property, and were reluctant to push a swath of firms immediately into restructuring.

This forbearance may not continue. We think much depends on the level of sales recovery for China residences in the second half of 2022, and going into the first quarter of 2023. This is when many of the extensions on distressed bonds expire.

If a sales turnaround is not forthcoming, investors will reject repeated extensions, and will be more likely to press their claims through a holistic restructuring or an in-court resolution. We saw an indication of this in investors' recent rejection of a request for an extension on an Evergrande bond.

Frequently Asked Questions

How are bond defaults in China's property sector resolved currently?

Distressed exchanges and maturity extensions are the most common resolutions.

Since 2018, in the offshore market, more than 142 corporate bonds issued by about 36 developers have been in default. Forty-six of those defaulted bonds have been resolved. In the onshore market, 45 of 97 defaulted developers' bonds have been resolved. Exchanges have accounted for nearly 79% of the resolved defaults on offshore debt, and extensions have accounted for 72% of the onshore resolved defaults since 2018.

Chart 1a.

Chart 1b.

The cash payment that offshore investors have received in in-court restructurings of defaulted developer bonds is about 6% of the principal. For those restructurings that are handled out of court, the proportion is about 12%. The property sector's cash payment is much lower than the overall cash recovery rates of the offshore market (see "China's Surging Defaults Test Courts And Bond Recovery," published May 5, 2022, on RatingsDirect). This is because developers most commonly use exchanges and extensions, and most of the value in such transactions lies in the newly issued or extended bonds. The final recovery rate will be determined by how the exchanged and extended bonds are resolved.

Chart 2

Why have developers used exchanges and extensions so heavily to resolve their bond defaults?

Developers believe they are dealing with a short-term liquidity issue, and are looking for time. Liquidity is tight, mainly because companies are increasingly unable to upstream cash from project companies. This means they do not have enough liquidity at the holding company level to repay their bond obligations in a timely manner. This is largely the result of large amounts of cash being trapped in escrow accounts, as housing delivery has been the top concern among regulators since Evergrande ran into financial distress in the second half of 2021.

The tight escrow rules won't ease substantially any time soon, even though there have been marginal relaxations in some local regions. Also, banks and trust companies are concerned about joint-venture counterparty risk, and hidden debt such as debt disguised as equity. These concerns, combined with a dramatic drop in contracted sales, have prompted creditors to pull capital, creating liquidity stress for developers.

Regulators have also required financial institutions to distinguish project risk from enterprise group risk, implying the higher priority of project funding support, versus group-level debt refinancing. Even if developers are willing to sell assets or projects to raise liquidity, the timing and size of such sales are often out of their control.

Exchanges and extensions are typically the most realistic liquidity solutions for distressed developers while maintaining operations and housing deliveries.

Creditors have been willing to give room to developers to restore their liquidity. This implies a hope among investors that the property market will turn around after regulators ease some of their more restrictive measures. This forbearance can translate into flexibility on terms for exchange and extension offers, provided that lenders deem developers' liquidity stress as transitory.

How do we view bond exchanges and bond extensions?

We treat the events as a de facto restructuring and as equivalent to a default, if the following conditions are met: the restructuring offers less than the original promise; there is a realistic possibility of a conventional default without the restructuring.

Do our ratings on issuers remain as 'SD' (selective default) after they announce an exchange offer or bond extension?

An 'SD' rating is assigned when we believe the issuer has selectively defaulted on a specific issue, but it will continue to meet its payment obligations on other issues or classes of obligations in a timely manner. We might set an issuer rating at 'CC' if the company announced an intention to restructure debt that we classify as distressed. Upon completion of this restructuring, we would likely lower our ratings on the affected issues to 'D', and set our issuer credit rating at 'SD', assuming the issuer continues to honor its other obligations. We would rate the entity at 'D' if the restructurings were more generalized.

After completion of a distressed debt restructuring, an entity ordinarily will be in better shape financially. This may ultimately lead to higher ratings than prior to the debt restructuring. For example, we upgraded our ratings on Greenland Holding Group Co. Ltd. to 'CCC-' after it completed a debt restructuring in June 2022.

On the other hand, if there is continued uncertainty about an issuer's ability to repay debt or there is a high likelihood of further restructurings, we may maintain the ratings at 'SD'. For example, our rating on Guangzhou R&F Properties Co. Ltd. has remained at 'SD' since April 2022. The issuer has meanwhile completed its second distressed debt extension (see "Guangzhou R&F Downgraded To 'SD' On Distressed Debt Extension; R&F (HK) Affirmed At 'CC' With Negative Outlook," published April 8, 2022, on RatingsDirect).

Why don't onshore extensions trigger offshore cross-defaults?

Most likely because the onshore bonds had their terms amended and extended so they are no longer due. As such, it may not exceed thresholds that trigger an offshore cross default.

Are we expecting more exchanges and extensions in the next six months? Could such actions be a solution for distressed developers?

The number of new defaulters is likely to fall with the sales recovery in the next two quarters, and with many weak issuers having already defaulted. That said, the potential for default remains high because the property sector still faces US$73 billion of maturing bonds in the second half in the onshore and offshore markets.

Developers' capital structures have not improved much given that most exchanges and extensions will be maturing within one year. As such, if sales and refinancing do not improve as developers expect, we could yet see more rounds of exchanging and extending over the next few months.

We don't expect such actions to be a permanent solution. Liquidity stress could turn into insolvency risk if the market recovery comes more slowly than we now assume. We expect an "L-shaped" recovery for housing sales in China. This takes into account flagging confidence among homebuyers given the current economic deceleration in the country. The liquidity risk of more than one-fifth of rated developers could turn into insolvency risk (see "China's Property Downcycle Won't End With Policy Easing," April 6, 2022). As such, holistic debt restructuring will likely take place either out-of-court or in-court, prompting even more liquidation cases in future.

Are more in-court resolutions likely? What might make in-court resolutions problematic?

In-court restructurings or liquidations are likely for some developers if creditors become frustrated with repeated exchanges and extensions. This may make investors skeptical that a developer can turn around its credit profile.

If investors are at all reluctant to initiate an in-court restructuring, it would be because they believe the process is time-consuming and that cash recovery ratios are low (see "China's Surging Defaults Test Courts And Bond Recovery," May 5, 2022). This issue was apparent in Goocoo Investment Co. Ltd.'s onshore, in-court restructuring. The Hefei-based developer defaulted in 2018, and the court only approved the restructuring plan in December 2021. The restructuring proposal shows that the cash received by senior unsecured creditors immediately after the restructuring was only 5% of money owed.

The final recovery will depend on the value of equity if creditors choose a debt-equity swap, or opt to wait 10 years for the possibility of full repayment if they choose a debt extension. The restructuring investor and the group are prioritizing the completion of existing projects, and protection of interests of homebuyers.

Goocoo Investment is a small and regional developer. The in-court restructuring process is more complicated for larger developers given the number of projects they have across the country and the large size of their debts.

Another concern for investors is the uncertainty of enforcement of offshore court decisions within the onshore market. If an offshore company has no assets to its name, creditors would find it challenging to trace an entity's debt to the onshore, cash-generating entity. This is particularly true when there is no guarantee of the offshore debt by the onshore entity, or when domestic courts do not recognize the authority of offshore liquidators.

In onshore court restructuring, the offshore bond's structural subordination matters. This subordination was apparent in the case of The Peking University Founder Group (PUFG). In this high-profile default, the onshore courts and administrators declined to recognize keepwell claims on PUFG (see "Peking University Ruling Raises Refinancing Risk On US$93 Billion Of Keepwell Bonds," Sept. 2, 2020).

Technical issues also made the onshore court restructuring more challenging for offshore investors. For example, transferring cash payments to offshore bondholders may be subject to foreign exchange regulations, or the need for offshore investors to get approval from regulators to own shares in the onshore entity (see "After A Massive SOE Default, China Rethinks Resolutions", July 18, 2021).

Table 1

Is there different treatment for onshore and offshore bondholders?

It is not uncommon to see different restructuring terms involving the same issuer, for onshore and offshore bondholders. For example, many onshore bonds extend the maturity without any cash incentives, while many offshore bonds exchange for new bonds with some cash to sweeten investors. This is likely due to differing standards and practices for debt restructuring in the two markets.

In some cases, the issuer's offshore bonds have been exchanged while the onshore bonds are repaid in full and on time (see table 2). This is likely down to the differing bargaining power of the different investor groups.

Also, different legal systems could lead to different preferences for creditors. Offshore creditors have more flexibility to use lawsuits to exert pressure on debtors, while onshore creditors are inclined to accept maturity extensions to avoid a conventional default. This is reflected by the recent winding-up petition in Hong Kong against Evergrande from a creditor, for failing to pay US$109.91 million.

Table 2

What has the Chinese government done to facilitate post-default resolutions?

The government is helping to facilitate restructurings. A typical example was seen in the workout for China Fortune Land Development Co. Ltd. (CFLD) debt. Support from regulators and the local government ensured the restructuring was finalized in a single year.

Developers are facing a more complicated situation than other sectors in terms of the ranking of priorities among debt held by professional investors, liabilities to upstream suppliers and construction contractors, housing delivery to homebuyers, and money owed to retail investors. Regulators need to balance financial risk and social stability. Property projects span the country and court jurisdictions, increasing the complexity of the developer's debt restructuring. As such, local government officials and regulators may be forced to get involved, helping steer the process to completion in a reasonable time.

Governments can also provide funding support. Local government-led rescue funds and local government financial vehicles will be the typical entities backing such a support, providing liquidity relief to developers. That said, most of this support is aimed at mitigating project-level risk by acquiring a project's equity or debt, rather than directly helping a firm repay bonds, which are typically issued at the holding company level.

Moreover, governments' reduced revenue and increased spending (to prevent COVID and stabilize local economies) reduces their capacity to support faltering developers. Indicatively, the progress of CFLD's debt restructuring largely depends on the pace in asset disposals to local governments, according to press reports. Some creditors will likely delay signing off on the restructuring deal if they have waning confidence that lower-tier governments will stick to their commitment to buy CLFD's projects.

Why is there is no recovery rating from S&P Global Ratings for debt issued by Chinese corporates?

We do not assign recovery ratings for debt issued by Chinese corporate issuers since we have not assigned a jurisdiction ranking assessment for China (see "Methodology: Jurisdiction Ranking Assessments," Jan. 20, 2016). Also, Chinese corporate defaults have become meaningful only since 2018. There are not enough data points to assess how insolvency proceedings in China are likely to affect post-default recovery prospects for creditors.

Editor: Jasper Moiseiwitsch

Related Research

• Greenland Holding Upgraded To 'CCC-' On Completing Distressed Maturity Extension; Outlook Negative, June 29, 2022
• China's Surging Defaults Test Courts And Bond Recovery, May 5, 2022
• Guangzhou R&F Downgraded To 'SD' On Distressed Debt Extension; R&F (HK) Affirmed At 'CC' With Negative Outlook, April 8, 2022
• China's Property Downcycle Won't End With Policy Easing, April 6, 2022
• Recovery Rating Criteria For Speculative-Grade Corporate Issuers, March 8, 2022
• R&F (HK) Upgraded To 'CC' On Completing Distressed Tender; Guangzhou R&F Affirmed At 'CC'; Outlooks Negative, Jan. 17, 2022
• S&P Global Ratings Definitions, Nov. 10, 2021
• S&P Global Ratings Definitions, Jan. 5, 2021
• After A Massive SOE Default, China Rethinks Resolutions, July 18, 2021
• Peking University Ruling Raises Refinancing Risk On US$93 Billion Of Keepwell Bonds, Sept. 2, 2020
• Recovery Rating Criteria For Speculative-Grade Corporate Issuers, Dec. 6, 2016
• Methodology: Jurisdiction Ranking Assessments, Jan. 20, 2016