Offshore bond deals from Chinese issuers increasingly feature credit enhancement structures of questionable quality and the trend is no longer limited to investment grade names – similar high yield credits have recently started to be accepted by the market, according to Fidelity Worldwide Investment.
Over the past six months, Chinese companies have started to issue bonds with special corporate structures. The market for this is relatively small – with 16 companies and around US$16 billion worth of bonds. A majority of this issuance is from investment grade entities issuing in US dollars or CNH.
However, high yield issuance, where structural risks are more important, is growing in both currencies. Some of the structures are reasonably sound, with legal guarantees entitling offshore bondholders access to the company’s onshore assets. But others, such as keepwell agreements and letters of support, are not legally binding, and it is uncertain whether or not they would stand up in a court of law.
“There is something called a deed of equity interest purchase undertaking which sometimes gets signed along with keepwell agreements,†said Sabita Prakash, head of Asian fixed income at Fidelity.
This is some form of agreement whereby if there is a gap which needs to be met in terms of the bond repayment, the onshore parent company will agree to buy a stake in one or more of its subsidiaries offshore, which is sufficient to honour the debt commitment, regardless of the underlying value of that stake.
“These structures are designed to provide credit enhancement because the company can’t or won’t get a formal guarantee approved by Safe [the State Administration of Foreign Exchange]. Arguably these credit enhanced structures are designed to try and circumvent regulatory process,†said Bryan Collins, fixed income portfolio manager at Fidelity.
So when push comes to shove and one of these guarantees is tested, whichever regulator is involved may react negatively to the attempt at circumvention, which is a big risk, he said.
“It seems that the issuers themselves are quite aware of these risks, because you’ll never find these equity repo agreements by themselves, they always come with a keepwell agreement. It’s almost like the issuers are trying all kinds of ways in order to show that they are really sincere about keeping bondholders safe but without any of the regulatory approvals,†said Prakash.
Companies that have issued bonds with credit enhancement structures include Amber Circle Funding, Azure Orbit International, China COSCO, China Resources Cement, China Vanke, China National Petroleum Corp, Gemdale, Hainan Air, Longyuan Power, Skysea International Capital, Sinopec and Zijin Mining in the US dollar market, as well as Aviation Industry Corporation of China, Beijing Capital Land, China Construction Bank, China Datang Corp, China Easter Air, Cinda Asset Management, Dalian Port, Pointer, Shougang Holdings and Zhongce Rubber in the dim sum bond market.
“The second point to reiterate is that these companies set up a shell company offshore, and in order to borrow money they need some kind of guarantee otherwise no one in their right mind would lend them any money,†said Collins.
“A lot of these bonds don’t have credit ratings, but among the ones that do the approach really does vary. Sometimes the guarantee will add one or two notches, sometimes none. That variability comes from a very wishy-washy assessment of how strategically important a company may be to a particular group, or how important that company or industry might be to the Chinese economy.â€
Fast track
Credit enhancement guarantees have allowed more companies to issue offshore and raise funds much sooner than they would otherwise be able to.
“[Otherwise] they would have had to get a guarantee, which can take many months, sometimes even years. Alternatively if they were an onshore company, they might have had to list offshore, migrate their A-Share across to Hong Kong, maybe engage in offshore private equity funding, or pre-IPO funding and then eventually come to the bond markets,†said Collins.
“That process can take years. So this has just allowed capital to be raised offshore in an arguably more efficient way, but then you do have to start asking some questions. Are the credit enhancements that we as creditors are being offered appropriate, and are we as creditors pricing in those credit enhancements appropriately.â€
Credit enhancement structures are not totally unusual, and appear around the world from time to time, he said. But more recently the structures have moved down in quality, with more keepwell agreements and fewer letters of guarantees from banks.
“As the markets continue to take these agreements of weaker quality and get comfortable with them we have continued to see the issuance grow. And we’re likely to see this kind of issuance continue to grow,†he said.