Bonds in a flap

Tunghsu: China's high-yield chickens coming home to roost

Investors roasted through another default from the industrials sector, as the spotlight falls back on the domestic audit industry.
It’s a question with which China’s regulators are becoming increasingly familiar. How does a company that reports a comfortable cash balance one moment not have the financial resources to meet the coupon or principal payments on its debts the next? 
This week’s teaser comes from the Tunghsu Group. On November 18, the group’s chief operating subsidiary, Dongxu Optoelectronic Technology, missed a coupon payment on a Rmb800 million ($113.8 million) MTN issue and failed to repay a Rmb1.87 billion bond after investors triggered the latter’s put option.
Yet the group’s recent financials recorded an apparently healthy liquidity position. 
According to S&P Global Market Intelligence data, the parent reported cash and short-term investments of Rmb56.794 billion in June. Its database also shows that the company purportedly had a net/debt-to-Ebitda ratio of 2.7 times and an Ebitda-to-interest coverage ratio of 1.3 times.
Tunghsu’s onshore repayment difficulties have also put its offshore bond at risk of cross-default, following the announcement that it is seeking to transfer its 51.46% stake in its Hebei-based offshoot to Shijiazhuang State-owned Assets Supervision and Administration Commission (SASAC).
The group’s $350 million 7% June 2020 bond sale was issued in the name of Tunghsu Venus Holdings in June 2017 with a guarantee from Tunghsu Group. It has become a new lightning rod for the mounting default risks facing international bondholders that piled into single-B rated Chinese industrial credits at the height of 2017’s bond market bull run.
Most of those deals had three-year tenors. This means that the market is facing a potential flashpoint in 2020 when they reach maturity. 
In its October monthly Asian bond market report, HSBC noted that there is $6.24 billion worth of dollar-denominated bonds issued by Chinese high-yield industrial credits, which mature next year. Most of them are being quoted at steep discounts to par. 
Tunghsu’s June 2020 bond, for example, fell more than 20 points after the news broke on Tuesday and was being quoted at just 45 cents on the dollar as of Thursday. Goldman Sachs acted as the deal’s bookrunner at launch, with China Citic Bank International as joint lead manager. 
At that point, the bonds had a B+/B credit rating from Fitch and S&P. The former agency withdrew its rating in May this year, while the latter downgraded the bonds to B- in February and then to CCC- with negative outlook this week.
Charles Macgregor, head of Asia at independent credit research boutique Lucror Analytics, says that Tunghsu’s problems represent another fail by the rating agencies. He told FinanceAsia that they should “decline to rate these companies” since it would have made it much harder for them to access the dollar-denominated debt markets. 
Do their rating stamps and the brand name of the world’s largest international investment banks provide bond investors with a comfort blanket that, in retrospect, can so easily be snatched away?
The reality is that it should always be buyer beware when it comes to weak credits accessing public markets during late-stage bulls runs. For no matter how much due diligence the banks and ratings agencies undertake, investors know that they are both ultimately reliant on the auditor of the company in question. 
In this case, it was Zhongxingcai Certified Public Accountants (CPA). Lucror’s Macgregor says his company’s information indicates that the Beijing-based auditor is the subject of four different government investigations. 
This is backed up domestic news outlets. Sina Finance reports that Zhongxingcai has been sanctioned a number of times for inaccurate audits over the past three years.
It also highlights how Tunghsu jumped 121 places up the Fortune 500 China rankings during 2018 to reach the number 299 spot, one of the five fastest risers. And perhaps most importantly of all, it flags that Tonghsu’s money was deposited in Hengshui Bank in which had a controlling 50.3% stake. 
The group's Shenzhen-listed entities – Tunghsu Optoelectronics and Tunghsu Azure Energy – were both suspended from trading on Tuesday. 
The failings of China’s domestic audit industry have been increasing in tandem with tighter financing conditions and an onshore liquidity squeeze, which has exposed fraudulent accounting practises. The problems ultimately stem from the government’s former strategy of trying to build domestic champions at the expense of the big four global auditors with local operations: Deloitte Huayong, Ernst & Young Hua Ming, KPMG Huazhen and PwC Zhong Tian.
Rapid M&A between domestic auditors meant that not every acquisition was fully consolidated. This left rogue management teams free to act in cahoots with fraudulent companies, which also felt they had little to fear from the small fines the regulator currently imposes compared to other markets.
The fallout from this makes China a nightmare for international investors to navigate at a time when global bond and equity index providers are rapidly ramping up its companies within their indices.
At the most basic level, many offshore fund managers struggle to pronounce the names of potential Chinese investments, let alone locate them on a map. All remain acutely conscious of the potential pitfalls they face investing in companies whose audited financials they do not trust. 
It is one of the reasons why the US Public Company Accounting Oversight Board (PCAOB) has been in a well-documented spat with the Chinese government over its lack of access to inspect the domestic audits of US-listed Chinese companies. America’s trade advisor, Peter Navarro, recently told CNBC that “fraud is ubiquitous” among Chinese companies. 
This year’s most high-profile cross-defaults among Chinese high-yield industrial credits can be traced back to flawed audits. 
The first concerned Kangde Xi Composite Metals back in January. The company’s chairman was arrested for embezzling funds in May.
In July, the China Securities Regulatory Commission (CSRC) launched an investigation into its auditor, Ruihua – China’s second-largest domestic audit firm. It has also pledged to increase fines and jail sentences for corporate malfeasance. 
Then in June, Reward Science & Technology Company filed for bankruptcy after triggering cross-defaults on its dollar bonds last December. Its auditor, Zhongxinghua, was suspended from conducting any debt-financing business for six months starting in July.
The regulator said that it had failed to follow up on a substantial number of missing documents and that it had not verified assets properly during its 2017 audit of the Reward group (also known as Luowa).  
Goldman Sachs analysts predict rising corporate defaults. In a research note published this October, they said that they were sticking to their 3% default rate for Asian high-yield credits in 2019. 
Over the past month, investors have started to focus in on Shandong Province where a number of distressed high-yield private sector industrial credits are based. This follows the news that corn and steel processor Xiwang Group had defaulted on Rmb1 billion of its commercial paper in late October. 
At the top of the list are chemical groups Shandong Yuhuang and Zhongrong Xinda. 
The former has a $300 million 6.625% March 2020 bond outstanding. This is currently rated CCC+/CCC+ by S&P/Fitch and is trading at 75 cents on the dollar. The company’s auditor is Zhongxinghua.
The latter has a $500 million 7.25% October 2020 bond outstanding. It is currently quoted at 46 cents on the dollar and has a CCC+ rating from S&P. Fitch withdrew its rating in September. Its auditor is Zhongxingcai. 
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