It will take a long time for investors to get their money back--and they might not get much. That's the outlook for recovery on China defaulted bonds, according to panelists and participants at a recent S&P Global Ratings conference.

Tough conditions in China have led to an unusually large jump in bond defaults since 2021. Many of the defaulters are in the property sector and, in the past year, such issuers have been "buying time" with debt extensions.

"Time is running out for the issuers," said Christopher Lee, who moderated a panel on restructuring at 2023 Asia Corporate Outlook Conference. "Investors are losing confidence that defaulted developers will be able to raise cash through home sales or asset disposals."

At the same time, said Mr. Lee, improving underlying conditions could also facilitate workouts.

Hashing out deals will be tough. Key questions include recovery rates, time frames, the likelihood of debt-for-equity swaps or other structure, and the prospects for offshore investors versus onshore.

These questions were addressed at our annual conference on the outlook for Asia's corporate credit sector. The flagship event was held in mid-January, with more than 1,000 attendees. Those who missed the event can register here for a replay. This is one of two reports derived from the conference; the other is titled, "China And Fed Pivots Bring Great Contradictions With Great Expectations, Panelists Say".

Does China's Property Market Have More To Fall?

S&P Global Ratings estimates national property sales will drop by a further 6%-8% this year, after a nearly 28% decline in 2022. In value terms, sales will likely fluctuate between Chinese renminbi (RMB) 10 trillion and RMB12 trillion in 2023, down from RMB18 trillion at the peak of China's property cycle.

Optimism is growing, however, given China has lifted severe COVID restrictions and widened support to the property sector. The majority of those polled at our conference expect prices to be stable or fall while a minority of voters anticipate sales will improve modestly. The biggest chunk (nearly 46%) anticipate sales will move by between -5% and +5%. And nearly a fifth foresee an increase of up to 10% (see chart 1).

Chart 1

Developers missed payments on more than US$30 billion in offshore bonds in 2022. Hence, stabilization in the residential property market and generating sales will be the key to the resolution of bond defaults.

"Real estate property sales haven't meaningfully recovered, although a lot of our clients have expressed optimism on their side," said Sophia Xia, co-head of China Restructuring at Houlihan Lokey. "So I think once you see the bottoming, then prospects for recovery rates will rise, and that will be reflected in bond prices."

Even if the issuers finally start to come up with solutions to cure the default---it could easily be another two years before investors start getting their money back.

Ms. Xia thinks investors might have to wait a while for many of the defaulted developers to really fully recover and start servicing their offshore maturities.

Chart 2

Two Years Or Longer? Recovery Rates And Time Horizon

Some 80% of those polled at the event expect recovery rates of 0%-30% (see chart 3). These rates are in line with market prices on defaulted bonds.

Chart 3

Howard Lam, partner at Latham & Watkins, said he was "cautiously optimistic" that more defaulted bonds would get restructured later in the year, as prospects for a more stable market bring borrowers and creditors to the table.

Mr. Lam noted that more than 40 developers have defaulted since late 2021. Many of these companies have been in restructuring talks, and there has been quite a few term-outs. But very few have completed a holistic restructuring and got their debt trading again. And some have already missed payments post-restructuring.

If "Amend And Extend" Was 2022's Story, What Will 2023 Bring?

Debt-for-equity swaps will likely feature in solutions to workouts. This year has already seen one such deal proposed, by Chinese developer Fantasia Holdings Group, which offered a partial debt-for-equity swap in its US$4.5 billion restructuring proposal.

Ms. Xia said that creditors might be open to this type of solution, given such holdings align their interests with those of the controlling shareholders. She noted that investors who chose the equity option in a 2016 restructuring by the developer Kaisa Group Holdings "actually got better recovery," because equity price ran up a lot more than the bonds.

Of course, in 2016, the market was still booming, making it easier to pull off such deals. In 2023, no one expects a new property boom in China. Thus investors may accept equity swaps not on hopes of outsized upside--but because, realistically, their options are limited.

"Creditors and issuers are much more realistic about what they could get and they might need to compromise to get a deal done," said Mr. Lam.

In short, if creditors were asked to compromise on the principal amount of debt, they would expect to be compensated in other ways. This could include:

• Equitization (e.g., equity-for-debt swaps);
• Large paydowns upfront;
• Tighter debt documents;
• Some ring-fencing of assets for debt repayment.

Issuers will also need to compromise, including giving up some shareholding at the listed company level. Ms. Xia said she believes some issuers would be willing to provide potential equity upside. It's best not to dilute too much, which waters down the incentives of shareholders to "stay in the game" and drive the business to profitability.

Would Wind-Ups Be A Feasible Option?

"I think some investors are saying enough is enough," said Mr. Lam. "If there's no proper engagement, and bonds are trading at 5 or 10 cents on the dollar, then some creditors will understandably be willing to threaten to wind up the company."

In July 2022, a small group of creditors petitioned Hong Kong courts to wind up offshore vehicles held by China's largest defaulter: developer China Evergrande Group. This is one of several such petitions against defaulted issuers in recent years.

Such actions "put pressure, undoubtedly, on the issuer to address their debt problems," said Mr. Lam

However, the Hong Kong courts have been giving defaulted developers some time to come up with a plan. In many cases, the courts will grant extensions as long as they can show they're making progress toward a plan. Thus such petitions can incentivize bringing all parties to the table.

Ms. Xia, on the other hand, sees liquidation as a "last resort," and says that liquidation can scuttle prospects for a debt restructuring.

Will Offshore Investors Be Last In Line?

Offshore investors are structurally subordinated and have relatively fewer ties to governments and influential parties that often arrange workouts or support for distressed issuers. Nonetheless, some recent onshore developments could benefit offshore investors.

For example, Ms. Xia noted that domestic creditors are providing long-term extensions to troubled borrowers. Rather than having to roll over debt every six months to one year, borrowers are increasingly getting four- to five-year extensions.

"This means onshore unsecured creditors, at least, are more or less taking a longer view--which is quite beneficial to offshore creditors," said Ms. Xia.

Mr. Lam noted that besides legal and structural disadvantages (e.g., no direct offshore recourse to onshore assets, in the form of guarantees, or security), what is often most frustrating for offshore investors is the lack of engagement and transparency in the "process".

In his view, most issuers would actually rank on- and offshore investors equally, when they have exposure at the same level.

"There's an intention at least by issuers to treat offshore and onshore investors pari passu in restructurings when the debts are issued or guaranteed at the same level," said Mr. Lam. "I think the frustration has been the process--in which the onshore creditors get to engage with the issuer a lot more, and a lot earlier. The formulation of the plan, therefore, has been skewed toward the requirements of the onshore creditors."

Will Offshore Markets Reopen?

Quite a few conference-goers think the market could reopen this year for speculative-grade issuers (see chart 4). But will the structure of such bonds be different, given the credit events of the past 18 months and the perception that offshore investors are last in line? Mr. Lee put this question to the panelists.

In response, Ms. Xia noted that the main source of compensation will come via higher yield.

"If creditors are willing to subscribe to new issues without any structural enhancement and just being compensated by their yield, then of course, there is less incentive on the issuer's side to do anything extra," she said. "But I think for the market to reopen, we will likely have to see some structural enhancement as well as economic benefits to rebuild the trust."

Supports rolled out by a number of domestic regulatory bodies, including the bond-guarantee agency, should improve confidence.

Moreover, the benefits of these policy uplifts go to the survivors. Ms. Xia said that incentivizes developers to resolve their offshore issues. Because only then can they get on the "white list" of companies that can enjoy most of these supportive policies.

Chart 4

Watch This Space

Mr. Lee, the moderator, finished off with his view that this will be an eventful year for restructurings.

"Some issuers are not playing ball," he said. "However, this year should see some real restructurings as alignments coalesce between the owners and the creditors, and other shareholders."

At the same time, we probably "still have some misalignment," said Mr. Lee. And in those cases, we could see winding-ups.

The road to restructuring and recovery is a long one, and will continue to require patience.

Writer: Cathy Holcombe

Related Research

• China And Fed Pivots Bring Great Contradictions With Great Expectations, Panelists Say, Feb. 28, 2023
• China's Earlier Policy Shift Advances Its Recovery, Jan. 18, 2023
• China's Defaulted Developers Hope For The Best, Prepare For The Worst, Jan. 10, 2023
• China's Surging Defaults Test Courts And Bond Recovery, May 5, 2022
• A Surprise Test For China Offshore Bonds With Keepwell Deeds, May 26, 2020

Appendix

Table 1