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A Stock Picker's Tale of Greed Hits the Bond Market

Shuli Ren

(Bloomberg Opinion) -- All of a sudden, bond traders are crossing paths with short sellers, and things are getting messy.  

Bringing them together is a growing list of Chinese corporate accounting scandals. Last week, Luckin Coffee Inc., a target of short seller Muddy Waters Research, admitted its chief operating officer may have fabricated billions of yuan in sales. Days later, TAL Education Group said an internal audit found an employee wrongly inflated revenue. Muddy Waters also said it's shorting shares of iQiyi Inc., tweeting that it believes the Netflix-like streaming service is a “fraud.” The company, backed by Baidu Inc., said the report contains “numerous errors.” 


At first glance, this is a story about stock investors’ irrationality and greed. These high-flying companies were cut off from the more analytical bond world, because they don’t have much by way of cash flow or tangible assets. At best, a few financially savvy ones like Luckin and iQiyi were able to issue convertible bonds, which are equity-linked instruments. 

But we’re talking about China, where corporate family trees matter, and stock holdings are often pledged away as collateral for loans. Now this web of hidden debt is ensnaring the bond market. Dollar bonds issued by Car Inc. — whose chairman Lu Zhengyao, or Charles Lu, is Luckin’s largest shareholder — have tumbled to deeply distressed levels.

While Lu’s car rental business has nothing to do with Luckin’s coffee shops, it may well share similar financing techniques, investors figure. Lu, it turns out, is a big user of pledged shares. He has taken out hundreds of millions worth of margin loans from Wall Street’s most prestigious banks. With Luckin tumbling over 80%, he’s no doubt getting margin calls. Lenders have seized $335 million worth of shares as of Monday.

For Luckin, margin calls will only hammer the share price; for Hong Kong-listed Car Inc., they could lead to a default. If the combined holdings of Lu and related parties — currently at 56% — drop below 35%, that could trigger a change of control clause for the company’s two dollar bonds with over $670 million outstanding, and force early redemption. But Car Inc. doesn’t have that kind of money: With a cash ratio of only 0.74, it can’t even cover existing short-term debt.

Because of a lack of disclosure in Hong Kong, we have no way of knowing how many Car Inc. shares Lu has pledged and may have to sell. But there’s good reason to believe he wouldn’t act any differently with his other businesses. Car Inc.’s largest shareholder, UCAR, which Lu controls, has put up 24% of shares outstanding for 1.4 billion yuan of bank loans as of last June, according to S&P Global Ratings. So the only rational thing for bond traders to do is to cut their losses. 

Meanwhile, convertible bonds can throw out nasty surprises, too. China Inc. sees these instruments as dirt cheap loans meant to become stocks — except when things get derailed by short sellers.

Consider iQiyi. It has two convertible bonds, with $750 million redeemable as early as December 2021 and another $1.2 billion in 2023. Both are deeply out-of-the-money right now. Will Baidu, the controlling shareholder, bail out iQiyi when the principal comes due? The bid-ask spread of bonds issued by Baidu widened Wednesday, as traders tried to process what this would mean for the investment-grade search engine, or whether iQiyi could trigger cross-defaults.  

Any time a stock dips, appetite for an affiliate company’s credit also suffers. In China, however, the relationship is more direct and consequences more brutal. Credit has always been tight for private businesses, so they can never have enough of it. That’s why they turn assets — land, factories, stocks, even the apartments they live in — into new credit at every opportunity. As a result, there’s no pecking order, stocks become debt and the two worlds converge. Muddy Waters just opened a Pandora’s box.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Shuli Ren is a Bloomberg Opinion columnist covering Asian markets. She previously wrote on markets for Barron's, following a career as an investment banker, and is a CFA charterholder.

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