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April 28, 2013 8:08 am
While growth in the offshore renminbi bond market has been impressive, sorting through the issues affecting the asset class and understanding the risks is becoming more challenging. These concerns are also relevant to wider market developments in China amid continued economic liberalisation.
The offshore RMB market has yet to face a real test in the form of a default in the high-yield space. It remains subject to credit structures that can be opaque, with loose or no covenant packages. This is why a prudent investment approach is important, paying close attention to the “standard of care” or fair treatment of all creditors, with the aim of keeping Asian market practices on a par with other global markets.
There has been a recent trend in offshore bond deals from Chinese issuers (in both dollar and offshore RMB denominated debt) in which so-called credit enhancements – such as guarantees, keep-well agreements, and letters of support – are being used to improve pricing and bring deals to market quicker.
These “enhancements” allow Chinese companies that cannot directly sell overseas debt to raise funds through offshore entities by providing assurances that the sales are backed by an onshore unit with assets.
Although the amount of issuance of credit-enhanced notes by Chinese companies remains relatively small, at about 10 per cent of around $100bn in total Chinese offshore issuance (dollar plus offshore RMB denominated debt), the trend is growing.
On the positive side, these enhancements are helping to diversify China’s debt markets by deepening issuance. They are also enabling many Chinese companies who could not otherwise raise overseas funds to tap offshore investors and broaden their sources of funding. On the negative side, these structures are untested and have not been pre-cleared by regulators, meaning that investors should be adequately compensated for the additional risk involved.
Not all of these enhancements fall into the same category. Investors should be comfortable with guarantees, or legal contractual obligations from the guarantor to make good any defaults by the company being guaranteed. These guarantees require pre-clearance from the State Administration of Foreign Exchange (SAFE) but typically they are rare. Letters of credit guarantees issued by banks are also acceptable and take the credit rating up to that of the guarantor.
Keep-well agreements and letters of support are more problematic. The latter are not legally binding and their good faith depends on the potential damage done to the reputation of the supporting entity should a default not be covered. Keep-wells – contractual obligations between the supporting and supported company – are also not subject to approval by mainland authorities and merely suggest willingness to keep the issuer solvent.
The danger here is that should insolvency occur, the regulator may react adversely and assess the added features as an attempt to circumvent accepted rules, meaning these deals should attract a risk premium. The recent petition for insolvency and restructuring by a Chinese renewable energy company (which has an offshore parent) underscores the importance of understanding these credit structures.
Although a majority of Chinese credit-enhanced issuance has been in the investment-grade space, it is also increasing in the high-yield market, where structural risks begin to take on increasing importance. This adds to the need for greater scrutiny of these “enhancements”.
Some keep-wells are being supplemented by a “deed of equity interest purchase” undertaking, in which any gaps in bond repayment amounts could theoretically be met by the onshore parent company agreeing to buy a stake in subsidiaries held by the offshore issuer – at a price high enough to honour any debt commitment regardless of the underlying value of the stake. The equity proceeds could then be used by the offshore issuer to pay back bondholders.
But again, these features are not subject to formal regulation and are untested in insolvency. The doubling up of keep-wells and equity repurchase arrangements also indicates a certain level of desperation on the side of issuers to convince debt holders that their money will be safe despite the lack of a full guarantee and regulatory oversight.
Ultimately, bond investors should demand compensation for lack of covenants or complicated structures that supposedly enhance creditworthiness but may simply disguise increased risk due to lack of full legal protection. The development of China’s bond market provides an exciting opportunity but it remains important to undertake careful due diligence and scrutinise those practises which may not be wholly positive for end investors.
Sabita Prakash is head of Asian fixed income and Bryan Collins is a portfolio manager at Fidelity Worldwide Investment
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