Zoomlion circus exposes China bond puzzle

November 4, 2013 8:40 am

Zoomlion circus exposes China bond puzzle

By Paul J Davies in Hong Kong

Who will be winners and losers as Beijing reforms state-owned firms? The tale of Chinese journalist Chen Yongzhou of the New Express Daily andZoomlion, a maker of diggers and concrete mixers, must seem completely bizarre to anyone outside of China. But it holds important lessons for investors, especially those holding bonds. The tabloid reporter was arrested last month then confessed on live TV to taking bribes to help an unidentified party defame the accounts of a large publicly listed, government-backed company. It sounds like a thriller, but it has become a lengthy saga involving accusations and denials of fraud and corruption flying in all directions, protests over press censorship from the newspaper and then an embarrassing retraction.Zoomlion has faced questions about its financing activities and cash flows since early last year. Then in January, it had to deny serious allegations made officially to regulators by anonymous sources that it had been falsifying sales. Vik Chopra, analyst at Sun Hung Kai Financial in Hong Kong, calls the whole saga a “circus”, while Julian Bu at Jefferies says investors are “free to take a view on the messy details and the conduct of all the parties involved”.

In truth, the Zoomlion circus should be read as a symptom of a much bigger battle – the fight for survival among companies in industries that are way over capacity. Beijing has unveiled ambitious targets for slashing production and closing plants in cement and steel. Many view this as just the beginning of a process that will see the government pick winners and losers across industries. Reform of state-owned enterprises has been touted as one of the big topics for the Communist Party plenary session starting on Saturday.

Bond investors in particular need to watch this process with great care and attention. Corporate bond issuance has grown hugely in China in the past couple of years – both onshore and offshore.

Bryan Collins at Fidelity in Hong Kong says Chinese corporate bonds made up only a 10 per cent share of the Bank of America Merrill Lynch Asia Dollar bond index in 2010, but now make up 25 per cent. Three-fifths of these bonds – or 15 per cent of the index – are issued by state-owned enterprises.

It is dangerous to continue to assume that “state-owned” equals “government guaranteed”.

“The Chinese government is beginning to differentiate between companies,” Mr Collins says. “We have seen this among fallen angels [companies whose credit ratings are cut from investment grade], a large proportion of which have been SOEs in recent months.”

Some companies don’t pass any of the tests that mean they should get support

– Bryan Collins, Fidelity

Bond prices and yields have gyrated wildly on changes even in mere perceptions of government support, according to Mr Collins. But this is not only about existing bonds, it is also about refinancing, too. Viktor Hjort at Morgan Stanley says Chinese SOEs face significant risks on this front because almost half their debt is short term, compared with just 14 per cent for investment grade Hong Kong companies, for instance.

The average SOE has a credit rating of BBB, while the average private industrial has a rating of BB to BB+, according to Fidelity. However, the financials tell the opposite story. Total debt is almost six times earnings before interest, tax, depreciation and amortisation at the SOEs, but less than three times ebitda at the private industrials. It may be banal to say that government support helps a rating, but it is eye-opening to see by how much.

In Zoomlion’s case, its total debt is actually less than its ebitda, while its net debt and leverage is falling, according to Fitch Ratings. But its bonds trade with a spread over government bonds of between 460 and 520 basis points.

This is more than the 400 to 425 basis points spread for Yanzhou Coal – whose business is similarly linked to the cement and steel industries. Yanzhou’s debt to ebitda is 1.75 times, it has big borrowing plans and its cash flow is declining according to Fitch. Both companies are rated BBB-.

One of these is obviously trading at the wrong levels. The whiff of scandal around Zoomlion does not help its case.

Mr Collins’ ultimate answer is to draw up a scorecard to assess the probability of government support. Is government support specified in law? Does the company have a policy or important strategic role for the country? How much does the government own and are there change of controls clauses if it sells?

“Some companies don’t pass any of the tests that mean they should get support – and yet they do,” he says. “You need to be more concerned about these.”