Chinese issuers are far and away the biggest source of bond supply in Asia. The country’s bond market grew to $12.1tr by the end of 2019, overtaking Japan as the world’s second-biggest bond market after the US. Chinese issuers also dominate Asia’s offshore bond market. Last year, they sold $216.4bn of bonds, representing nearly 64% of overall issuance in the region, according to Dealogic.
The sheer scale of this issuance means the fate of China’s bond markets is of importance to bankers, investors and issuers elsewhere. But the fact that China was the first country to be hit by the coronavirus — and looks likely to be the first to emerge from the crisis — makes it an even more important case study for those elsewhere. How have China’s bond markets endured the chaos unleashed by Covid-19?
The answer is complicated. Chinese corporations are spoiled for choice when it comes to bond issuance. Those looking to raise renminbi can sell interbank bonds or exchange bonds, tapping two domestic markets with different regulators and slightly different investor bases. They can also tap foreign investors with an offshore renminbi bond. Those looking to the dollar markets face a much easier choice, since the vast majority of deals are in Reg-S format. But even there, the investment grade and high yield markets are increasingly diverging in terms of investor appetite and the approach to execution.
On again, off again
The pandemic has led to a dramatic fall in onshore funding costs for investment grade issuers, making the domestic market an obvious choice to them. Indeed, Chinese investment grade issuers have largely returned home this year. In March, triple-A rated issuers sold Rmb2.83tr ($399bn) of bonds in the domestic market, 14.6% more than the same period last year, Wind data shows.
In contrast, the offshore bond market, an important funding source for China’s high yield issuers, has been patchy since the beginning of March, thanks to prolonged pandemic-triggered volatility.
Some investment grade issuers have braved the market — one notable example being Baidu’s $1bn dual-tranche bond at the beginning of April — but high yield issuers have struggled.
China’s real estate developers, who make up the majority of offshore high yield issuers, cannot take advantage of the funding arbitrage between the onshore and offshore markets. The country’s strict capital controls forbid them to move money from China offshore to pay back dollar debts. The pandemic has meant a sharp rise in their offshore funding costs and sadly there is not much they can do about it.
Chen Yi, head of global capital markets at Haitong International Securities in Hong Kong, says that a company rated single-B by global rating agencies would be expected to pay double-digit yields offshore, but could get away with between 8% and 9% in the onshore bond market.
“It’s another story for investment grade names,” he says. “It’s a lot cheaper for IG issuers to sell bonds offshore than onshore because the onshore yield curve is flat and there is not much of a spread between high-rated and low-rated names.”
That flat yield curve may finally steepen a bit this year thanks to Covid-19, which has spurred a widespread flight to safety among investors, something that is being reflected in China’s domestic market.
The Covid-19 pandemic has driven yields to historic lows for state-owned enterprises and highly-rated privately-owned enterprises. But as investors rushed to these safer credits, the funding cost for lower-rated issuers — meaning anything below double-A in China’s lopsided rating environment — have not declined as much.
The average three year credit bond yield for triple-A issuers had dropped by 76bp to 2.42% on April 21 from 3.18% on February 3, the day Chinese domestic market reopened after the Lunar New Year, Chinabond data shows. In comparison, AA-rated issuers, which are considered as high-yield issuers onshore, have seen their three year yields coming down only by only 43bp in the same period.
That divergence is set to deepen, says Ariel Yang, chief executive at CCX Analytics, the investors’ service sector of China Chengxin International Credit Rating. Yang is based equally in Hong Kong and Beijing.
“Investment grade bonds will be more popular this year and we expect their funding cost to have a more significant decline,” she says. “However, for most HY issuers, investors will demand more risk premium to partially make up for the decline in Treasury yields. We expect HY issuers to see a very limited decline in funding costs.”
An unintended benefit brought by the pandemic is that China’s onshore investors may be forced to draw a more detailed differentiation among credits that are all rated from AA to triple-A.
Onshore rating agencies, who tell GlobalCapital China their work should be judged by their reports more than the specific rating, still tend to give most deals a double- or triple-A rating. International observers have long called for an end to China’s top-heavy rating system. The coronavirus could force at least a small step in that direction.
“As the return on IG bonds and Chinese government bonds keeps going down, funds will have to take on more risk to achieve the targeted returns,” Linan Liu, head of Greater China macro strategy at Deutsche Bank in Hong Kong, tells GlobalCapital China. “Issuers rated AA and AA+ [onshore] may gain some traction this year. The polarisation of credits will continue but the breakdown of each class may go through some adjustments.”
Property rights
There are two key sources of Chinese issuance in the offshore corporate bond market: property companies and local government financing vehicles. They are likely to face very different funding needs this year.
The property market is the obvious starting point. Over 78% of high yield dollar bonds sold by Chinese companies in 2019 were from property firms, according to Dealogic.
Many property issuers, often rated AA+ or triple-A onshore but seen as high yield issuers offshore, have been able to sell three year notes onshore between 3% and 6% so far this year, Wind data shows. In the offshore market, however, it is not uncommon for them to pay anywhere between 8% and 12% for similar tenors, according to Dealogic data.
Take Evergrande Group as an example. The B1/B+ rated HY developer had to pay 11.5% for a $1bn three year transaction in mid-January. However, in the same month, the same issuer, rated AAA onshore, walked away with a Rmb4.5bn three year transaction paying only 6.98%, Wind data shows.
This makes the onshore market seem an obvious choice over dollar bonds. But the choice is illusory for many real estate issuers. With refinancing pressure increasing in both markets, developers need to tap both. As the pandemic rages on, there is not much they can do but swallow the rising funding cost offshore.
“Many people ask how real estate issuers make the choice between the onshore market and the offshore market,” says Cristiano Cui, managing director of Modern Land in Hong Kong, one of many HY property issuers offshore. “But for many of us, the practical question to ask is which market you can issue bonds in.”
Since last July, Chinese property developers have only been allowed to sell foreign currency bonds to refinance mid to long-term debt that is due within the next 12 months, part of a policy directive issued by the National Development Regulatory Commission, a powerful bond market regulator.
But the Covid-19-induced economic slowdown will likely force NDRC to loosen its grip on developers’ funding channels, bankers tell GlobalCapital China. Foreign investors will need to take some of the funding burden for property companies in the wake of the coronavirus.
The prolonged issuance from the property sector means it is now a much easier sell to international investors. “Investors have so much data across many cycles over the years,” says David Yim, head of DCM of Greater China and North Asia at Standard Chartered in Hong Kong. “The other sectors only have three to five names for investors to compare.”
The other source of Chinese offshore bond issuance is the country’s local government funding vehicles (LGFVs), most of which are rated investment grade. Unlike some real estate companies who have genuine offshore expansion or refinancing needs, many LGFVs have less clear motivation to issue dollar bonds.
Some LGFVs come to the international market simply because they wanted to be the first in their region to go offshore, say bankers. Others hope to get on the radar of foreign investors to help corporations in their respective regions attract foreign investments.
These deals also tend to appeal to a different investor base: less international, more homegrown. LGFVs often rely on the offshore branches of Chinese banks to drive deals, leaving some of their transactions executed more like club loans than public bonds. The risk-return means they are a good fit for relatively conservative city and rural commercial banks, says Terry Gao, head of Asia Pacific international public finance at Fitch in Hong Kong.
But this is one sector that should be able to sit out the volatility unleashed by the coronavirus. Only $12bn of offshore LGFV bonds are maturing this year compared with almost $30bn in 2019. But since LGFVs are only allowed to sell bonds in the offshore market for refinancing existing deals due within one year, the issuance volume this year is likely to experience a significant drop. GC