Euroweek Offshore RMB Report: Investor Protection

Euroweek, July 2011

Investors have been fervent in their appetite for Chinese-issued offshore RMB bonds. But in doing so, have they neglected due diligence, or even basic common sense? In an environment in which unrated issuers, who if rated would be well down the spectrum of high yield, are attracting multiple oversubscriptions for relatively low coupons, it is worth asking just how much risk investors are taking.

For one thing, there’s a big difference between buying the paper of a company that owns assets, and buying the paper of an offshore-issuing holding company that is linked to those assets. “In China, you’ve got an issue of structural subordination that arises,” says Matthew Sheridan, a partner at Sidley & Austin. “As a practical matter, it’s impossible to get guarantees from companies onshore for the offshore debt. An offshore holding company issues the notes, and they don’t have guarantees from the subsidiaries that own the operating assets in China.”

Lawyers are united on this. “When it comes to structuring, the first issue we often come across in China is the upstream guarantee or security issue,” says Joseph Tse at Allen & Overy. In many recent high yield bonds from PRC issuers, investors have wanted the issuers to provide security over assets in China. “Unfortunately, under Chinese foreign exchange regulation that is not possible,” says Tse. “To the extent that investors need security – and very often we see deals are not secured – they will have to settle for offshore security.” This means security over assets of the offshore holding companies, although “those assets typically just comprise shares in intermediate holding companies rather than hard assets.”

While these issues have long been problematic for dollar-denominated high yield issues from China, they are just the same for issues in RMB, if not worse. “Exactly the same issues in relation to taking of security arise whether the bond is denominated in RMB or not,” says Tse. “But with RMB bond issuance there is an extra layer of regulatory issues separate from the security issues, and the biggest of them is the repatriation of proceeds.”

It’s not as if investors are blind to this – or at least not all of them. “Investors are getting a huge premium in terms of the coupon on some of these issues,” says Sheridan. “There are some pretty savvy investors out there who think this is a great play.” But investors do seem to have decided that the merits of exposure to a rising currency with a decent yield outweigh the risk of losing everything in the case of a default.

“Investors have come to accept the fact that taking security in China is not straightforward at all,” says Augusto King, co-head of debt capital markets for Asia at RBS. It’s well understood that the vehicle they are buying does not hold assets, and that as a consequence the investors are going to be subordinate to onshore creditors. But, knowing this, they invest anyway. “With their eagerness to participate in the market, a lot of investors have gotten over this problem now. Instead they focus on how they should be paid for that structural subordination. But that problem – the ranking of offshore investors versus onshore creditors – is not going to go away.”

Opinion is divided on whether this is getting better or worse. On one hand, the experience of lawyers is telling. “In 2008, when the market fell apart, we thought China high yield would have to come back in a different form, and we started looking at structures to improve the situation,” says Sheridan. “But there is no silver bullet. There are structures you can put in place, but they have drawbacks and we couldn’t find enough interest on the bank side to take any of them to market, and then investor demand came back so there was no need to do it.”

That said, some bookrunners do report a shift in attitude in recent months. “In April, we saw a lot of credits without strong covenants issuing, because the asset side of the offshore RMB market is limited and there has been a grab for assets,” says Vishal Goenka, head of local currency credit trading for Asia at Deutsche Bank. “What has happened in the last few weeks is that some of the weaker credits have not seen the light of day. This is a marked difference from what has gone before. Investors are beginning to do some credit differentiation, and that is a good thing.”

While in some cases this differentiation will mean pulled deals, in others it just means more attention paid to covenant packages.  “In the past year, people were looking at CNH market deals with zero covenants,” says King. “But when we went out with corporate deals this year, investors said: can you put in some covenants, because we need to see some discipline. Now you’re already seeing that a lot of non-investment grade companies coming to the CNH market will have some covenants on the debt side, much like maintenance covenants.”

King doesn’t name the issuers he’s talking about, but it is understood that TPV Technology, which raised RMB500 million in three-year bonds in March, was an example of a Chinese issuer where potential investors said they needed to see covenants before being comfortable to invest.

Tse says covenant packages vary widely in the offshore RMB market. “In dim sum bonds, there could be a range from investment grade covenants to full high yield covenants, with a lot in between,” he says.  High yield covenant packages typically include restricted payment, debt incurrence, negative pledge, asset sales, transactions with affiliates and change of control. They sometimes extend to restrictions on mergers and consolidation, dividend payment, issuance of capital stock by restricted subsidiaries and others. “The covenant package will reflect the quality of the issuer,” Tse says.

Other bankers look to currency and rating issues. “The most important thing is the credit rating,” says Freda Wong, executive director, corporate finance at Citic Securities International. “Many of the privately-owned companies that are issuing bonds don’t have a credit rating, and some do not have a guarantee from the parent company. So credibility is a key point investors should pay attention to: Whether the issuer has the ability to honour interest repayments.”

And the ability to honour those payments isn’t just about creditworthiness: in situations where money must cross borders to service a bond, particularly in a controlled currency like the RMB, that adds another layer of uncertainty. “If they are issuing RMB bonds and will repay the principal or interest in RMB, then they need to remit RMB out of China to honour this obligation,” says Wong. “Has it conducted the right administrative procedures for RMB remittance? Normally that takes time.”

The question of the currency creates another set of risks, although the fact that the bonds are trading in one of the freest capital markets in the world makes it a curious situation.  “One investor risk that’s pretty clear cut is capital controls,” says Chia Woon Khien, managing director and head of local markets strategy for Emerging Asia at RBS. “If they impose capital controls in Thailand, your money can’t come out. But what’s the chance of Hong Kong imposing that? Next to nil. So you have an advantage there.”

But there’s also the fact that one is dealing in a controlled currency trading outside its home market. “The other side of it is that this is an offshore market, and the FX risk is greater in an offshore market than an onshore one,” says Chia. “The PBOC will intervene if necessary in the onshore debt market, but it’s not going to step into an offshore market to intervene. In the offshore market it will depend if the HKMA steps in – or the MAS, when Singapore issues bonds. It is up to the central bank in your jurisdiction where the bond is issued whether they want to intervene.

“Although in its physical form everything is CNY, the price of the currency is different between onshore and offshore,” Chia adds. “There could be an extreme event that creates uncertainty, and the offshore markets are subject to the reaction to whatever that event is. Onshore, you’re protected by a central bank; offshore, you’re on your own. So you have a bigger FX risk even though you might not see it now.”

Investors don’t yet seem to be going to third parties to insulate themselves against default risk. “In terms of buying actual protection, we’re not seeing anyone doing that,” says Xiang Hong, deputy head of global rates for Greater China at Deutsche Bank. “But it can be done: we have seen reinsurance companies covering political risks, and that could include China.”

It should be said that Chinese companies coming to market with less-than-watertight guarantees and covenants isn’t necessarily a sign of those companies seeking to hoodwink investors; there is, too, an evolution that needs to take place in the issuer base itself. “It [offshore RMB] is a good opportunity for Chinese issuers to go abroad,” says Tony Wong at Bank of China (Hong Kong).  “But there are several issues for Chinese issuers during this process – one is rating, another is corporate governance – before they are fully recognized by the international community.”