It should have been one of the year's landmark deals.
When property company China Evergrande announced an exchange offering for most of its short-dated debt on June 8, its actions were widely applauded.
Credit analysts and the ratings agencies all underscored the range of measures the company had been taking to improve its liquidity position and extend the maturity profile of its debt.
Standard & Poor's said it did not consider Evergrande's prospective $3.2 billion transaction a "distressed exchange" and assigned the new money bond issue accompanying it a B- rating.
Only one month earlier, S&P had rated the bonds being exchanged at the CCC+ level.
It should have been a story about a company moving back up the ratings scale and improving its credit metrics by imposing greater financial discipline on its balance sheet.
Instead, Asia's fund management community woke up on Thursday morning to discover the old adage about leopards and spots.
Overnight, Evergrande had printed a $6.62 billion three-tranche bond offering, of which $2.823 billion derived from the exchange and $3.8 billion was new money the three lead managers had sourced through a one-day bookbuild.
This $3.8 billion new money component was three to four times larger than fund managers had been expecting.
The reaction was one of deep shock and an immediate and sharp sell-off across the group’s equity and debt.
To put the size of this $6.65 billion tripled-headed Medusa into perspective - one of Asia’s lowest rated borrowers has now set the record for the region’s second largest bond offering on record (Alibaba tops the rankings with $8 billion according to Dealogic figures).
A fixed income head at one of the region’s largest fixed income fund managers told FinanceAsia, “There’s a fair bit of disgust about the way this deal’s been handled. As a result of this enormous transaction, China Evergrande now accounts for 6% of Asia’s high-yield market and 13% of China’s high-yield market.”
Indeed, just the $2.3 billion new money component of the longest of the three tranches alone would rank as Asia’s largest high yield bond in its own right. Together with the exchange component, that $4.68 billion 2024 bond also represents Asia’s second largest tranche on record behind Bank of China’s $6.5 billion additional tier 1 deal.
The reverberations may felt for some time.
Firstly, Evergrande is likely to have upset the Chinese regulators who reportedly stopped giving property companies permission to issue overseas debt during the second quarter. The new money component of an exchange offering skirts the existing rules, but to go ahead and raise $3.8 billion this way may be viewed by Beijing as an unacceptably rude gesture.
Secondly, the company has upset financial analysts’ calculations and unless it is using all the new money to retire more expensive debt, it will have put its leverage on an upward path again.
Thirdly, it will throw a pall over the rest of the Asian high-yield sector and most immediately, the prospects of a similar new money offering by Kaisa, which was in the market on Thursday with a new bond deal to accompany an exchange offering of its own.
Then there are the losses investors are now shouldering. Over the past few years, there have been plenty of instances where investors’ desire for yield has led them to loosen their price discipline when bidding for new bond offerings.
But in this instance, it appears to be a case of a borrower gobbling up every last bid from the table after failing to guide the market about how much money it really intended to raise from the B3/B-/B- rated deal.
“We were expecting up to $1 billion in new money not closer to $4 billion,” the fund manager added. “Evergrande has just crushed a lot of people and everyone is affected because the company is in all benchmarks and indices so the whole market owns paper.”
Fortunately, we only ever bid for what we want and don’t inflate orders in the expectation of being scaled back,” the fund manager continued. “Yesterday, however, we were getting feedback that demand was intense and we couldn’t be guaranteed an allocation.”
One of the markets momentum players had a similar tale to tell. “We were asking for guidance about how strong demand was and the likely deal size,” the London-based hedge fund manager commented. “We were getting very vague feedback so that was a big red flag for us and we didn’t participate.
“What a relief,” he added. “We’d have got smashed.”
Demand and allocations
Distribution statistics show that investors who placed orders for the four-year tranche would have been almost completely filled since the order book closed at the $525 million level and the new money component amounted to $500 million.
A further $98.1 million came from the exchange offering.
This $598.18 million 6.25% June 2021 tranche was also the worst performer of the three in yield terms.
By the end of the Asian trading day on Thursday, it had dropped from par to a mid-price of 95.81%. In yield terms, it widened 123bp to 7.48%.
The second tranche comprised a $1.345 billion June 2023 (callable June 2020) bond.
The exchange contributed $345 million towards it, with new investors accounting for the $1 billion on the back of a $2 billion order book.
This tranche dropped five points from is par issue price and was yielding 8.585% or 108.5bp wider by the end of the first day.
Finally, a $4.68 billion 8.75% June 2025 (callable in June 2021) offering was priced at par and dropped to 94.7% on a yield of 9.7%.
This had a split of $2.38 billion from new money on the back of a $4.7 billion order book and $2.4 billion from the exchange.
Private banking clients feel the pain
The distribution statistics show that private banking investors dominated in all three tranches. But unlike institutional investors, they are less likely to have participated in the exchange and are, therefore, currently sitting on pure losses.
They are also least likely to be able to bear those losses if they become forced sellers at some point.
Private banking accounted for 54% of the four-year tranche, 54% of the six non-call three and 62% of the eight non-call four tranche. Fund managers respectively took 34%, 44% and 25%, with banks on 12%, 2% and 13%.
In terms of geography, Asia accounted for 90% of the shortest and longest tranches and 84% of the middle tranche. Europe accounted for the rest.
The picture is better for institutional managers, which had participated in the exchange, although they will no doubt be ruing the loss of the higher coupon payments from the bonds they tendered.
But the terrible secondary market performance of the new deal has wiped out any gains they stood to make as a result of the premium they were offered over secondary market levels to participate in the exchange in the first place.
For example, Evergrande offered to take out its $1.5 billion 8.75% 2018 bonds at a price of 104.375%. In late May, these bonds were trading around the 103.5% level.
It subsequently achieved a 71.5% acceptance ratio.
It also offered to take out its $300 million 8% 2019 bonds at 106% compared to a pre-exchange price around the 103.75% level at the end of May.
It achieved a 66% acceptance ratio.
Evergrande also offer to exchange its $1 billion 12% 2020 bond at 115%. These bonds had been trading around the 111% level just prior to the announcement.
It achieved an 87% acceptance ratio.
Finally, it offered to remove a privately placed $400 million 7.8% 2019 bond. This achieved a 99% acceptance ratio.
The company may view the bond deal as a great success since it will have significantly reduced its funding costs over the short term.
In terms of credit metrics, UBS recently reported net gearing of 167% at the end of April (treating the company’s preferred bonds as debt), down from 432% at the end of December. Counting the preferred bonds as equity brings the ratios down to 120% (December) and 119% (April).
However, over the longer-term investors said Evergrande could end up paying for its behaviour. “The markets often have a very short-term memory,” one fund manager concluded. “But Evergrande will almost certainly be back for more debt in the future and fund managers will less trusting next time. That could well end up costing them.”
Joint global co-ordinators for Evergrande's deal were Credit Suisse, China Citic Bank and Haitong International.