The number of companies from China issuing offshore bonds guaranteed by standby letters of credit (SBLC) from banks is increasing and the trend is likely to continue, but investors are concerned that too much issuance could increase concentration risk and draw negative attention from regulators.
The trend is not specific to China – a number of Asian banks have provided SBLCs over the past few years, including DBS and State Bank of India, but issuance with a SBLC from the Bank of China (BoC) is gaining market share. This year, five Chinese corporations have issued bonds using letters of credit provided by various BoC branches, versus only one such deal last year, said Elaine Ng, senior analyst at Moody’s.
“We expect this trend to continue as Chinese corporations expand their business and banks benefit from the fee-based income in providing letters of credit,” she said.
Issuers that use SBLCs tend to be unrated and unable to raise capital through the bond market without a credit enhancement.
China International Marine Containers (unrated), China Shipping Container Lines (unrated), Hainan Airlines (unrated), China Zhengtong Auto Services Holdings (‘Ba3’) and Haitong International Finance Holdings (unrated) have all done deals this year.
All of the bonds have been assigned an ‘A1’ rating from Moody’s as they are seen as fully supported and therefore on a par with BoC’s own bonds.
The pricing benefits of SBLCs are clear. China Zhengtong, for example, raised US$335 million in five-year bonds in September, with a 4.5% coupon. In the same month, its wholly owned subsidiary, Wuhan Shengze Jietong Logistics, issued CNY350 million (US$57.4 million) one-year commercial paper with a 7% coupon.
Other benefits of SBLCs include longer tenors and better covenants for the issuer, said one head of Asia Pacific high yield syndicate at a global bank.
“Banks tend to do it for companies where they have existing lines in place, so it’s generally a recycling of existing limits from a funded line to a contingent liability. The borrower ends up with a longer-dated line and lower covenants, and it’s better for the bank’s capital requirements from a Basel III perspective, so it’s win-win,” he said. From an investor perspective, there are also benefits.
“Investors like the structure as at the end of the day they are getting the ultimate credit risk of the SBLC provider, with a pick-up. Some of these deals price 80bp to 100bp over comparable senior bonds,” he said.
However, while SBLCs allow international investors to gain access to the Chinese corporate market with limited credit risk exposure, they also effectively increase concentration risk.
“It’s a way to make people more comfortable with those names, but when it comes to supply if you have too much, its attractiveness will be diluted. You can’t have too much concentration risk from any bank and [the BoC guaranteed deals] are almost like the bank re-tapping, so it can’t go on forever,” said one fixed income CIO for Asia Pacific at a global asset manager.
Others argue that the credit risk is aggravated by the fact that guarantees may encourage issuers to take the market less seriously. “It allows companies to come to the market that may not have been able to otherwise, but then you have to ask whether they will get a little bit blasé about their interactions with the market, as they have standby support,” said Sabita Prakash, head of Asian fixed income at Fidelity.
Another problem is that market participants disagree about how the credits should be priced. Moody’s rates the instruments on a par with the underwriting bank. But investors do not believe this is the right approach.
“I will talk about pricing and you can infer what I think about the ratings. Pricing should be wider than the straightforward bank unsecured debt because anything with a structure is less liquid than the vanilla non-structured instrument. Also, the SBLC is supporting an entity weaker than itself, so the paper has to be treated differently to the vanilla equivalent,” said one head of Asia fixed income at an international asset manager.
The average pricing differential between a SBLC supported deal and a plain vanilla bond issued by the bank extending the SBLC is around 30bp to 40bp, but the premium demanded by the market is uncorrelated to the quality of the underlying credit, said Prakash.
“The individual credits are all over the place. There are many of these names supported by BoC and they all trade at different levels, which may or may not be related to their standalone rating, which is often undisclosed. To be fair the market is still trying to understand it as there have not been many deals with this structure. Even guaranteed instruments trade at least 10bp to 20bp wider, so it’s difficult to come up with a rigorous science for this.”
Other investors believe these deals should not be priced off the guarantor bank. “If one assumes that’s the way to view these deals then theoretically it could be any issuer, but we don’t think that is the way to treat it,” said Chia Liang Lian, head of Asia fixed income at Western Asset, in an interview with Asiamoney PLUS.
Another concern is that the structure has not yet been tested. Unlike with a guarantee, where funds are automatically available, if a bond with a SBLC goes into default, the trustee must raise a demand for payment with the guarantor bank.
Finally, banks are allowed to provide SBLCs through their offshore branches without onshore regulatory approval, but in a default situation, any remittance from an onshore to an offshore branch must be approved by the State Administration of Foreign Exchange (Safe). As such, SBLCs could be viewed by the regulator as the exploitation of a loophole, said Prakash.“Hopefully there isn’t too much more issuance as the regulators could very well see this as bypassing their regulatory clearances, and may come down quite heavily and change the rules. So it’s not in anybody’s interest for the market to grow too much,” she said.