IFR: It’s all part of trying to reduce this structural subordination for a company that has most of its assets onshore and is borrowing offshore.
WALLACE LAM, HSBC: Even if the company has no assets offshore, the keepwell is still stronger than a letter of support, which was previously used by some of the very large SOEs. The keepwell that we incorporated as part of the GEmdale deal, it was actually significant in being a contractual legal obligation. It’s not a financial guarantee but it offers commercial benefit and protection to investors that is actually close to being a guarantee. That’s the beauty of it – it’s a legally enforceable contractual obligation.
IFR: So Kalai, in a case like that would the overseas bonds not be notched down?
KALAI PILLAY, FITCH RATINGS: It’s a case by case approach, and in most cases they are not notched down, at least the way we look at it. It’s exactly for the reason Wallace said: there is a legally binding obligation on the parent here. On top of that, we also look at why the company is going through this convoluted structure to borrow. It’s not because they are trying to pull the curtains around something more sinister, it’s because of the constraints put on them by the government in terms of issuing bonds offshore. For this reason we have generally not notched down.
The way we approach it is to put all of the debt of the company in a waterfall and say what is the highest priority debt in event of a liquidation. Clearly the onshore guys always come first. After that, if there is an offshore guaranteed bond, we would put that there. We don’t have a legal opinion from anyone saying that is a superior structure, but we would put that ahead of the keepwell bond. Very rarely would you have a company with both – I think R&F is the singular exception with both structures, since they had a legacy guarantee from years ago and then came with a keepwell structure. That was an interesting case to put through the waterfall, but there was still sufficient recovery for the keepwell bonds that we did not notch down.
Generally, property is a sector where the asset base is high, quite often the land holding cost is quite historical and the current market value might be quite a bit higher, so you don’t need to haircut it too much either. This is a sector where you might not need to see that much notching, but in the industrial sector it becomes a lot more complicated.
IFR: Does it come to a point where the SAFE changes make the concept of a keepwell agreement redundant?
KALAI PILLAY, FITCH RATINGS: well the SAFE rule has a catch – you can’t bring the money back onshore. So if you want to borrow for your offshore projects, that’s fine. Greenland did one recently, and they have tons of offshore projects. But for many property companies the money is needed back in China, so that avenue is not available to them.
PATRICK LIU, UBS: UBS brought the first private-sector bond under a SAFE guarantee for Oceanwide Holdings, an A-share listed company. And with the SAFE guarantee we used a pure Western style high-yield covenant package for investors for the first time. There is a full security package including full financial covenants. That means the PRC incorporated companies can issue offshore high-yield bond. The deal has been well received by investors, and was the largest debut bond from the sector this year.
IFR: So that means offshore investors rank the same as onshore bondholders. It’s a shame it can’t work like that in every case!
PATRICK LIU, UBS: The client has onshore bonds outstanding. So yes, investors rank the same. It had an offshore use of proceeds, but for those who have to bring the money back there are still some restrictions.
WALLACE LAM, HSBC: The first company to use the cross-border guarantee structure was Greenland, which we did.
PATRICK LIU, UBS: Yes, but that’s not high-yield, and not from the private sector.
MICHAEL LEE, GUANGZHOU R&F: We got the guarantee in 2011 and then we had a very short window and it was a very speedy execution. Then the keepwell was introduced in 2012-13 and we issued under that. If you ask us today, if we could do both, which one would we choose? The question comes back to do investors appreciate it. If I come out with a guaranteed bond, do investors treat that as a guaranteed bond, or do they look more at the keepwell in pricing the credit. If I’m issuing a high-yield bond today and I jump through hoops to get the guarantee, I don’t want pricing to be based on my keepwell.
WALLACE LAM, HSBC: If I can try to answer that question, I think for other rating agencies – rather than Fitch – there is a rating differential between the keepwell and the guarantee. We don’t have that many precedents on this, but Greenland is actually a very good example. We have Greenland Hong Kong issuing under the keepwell, and we have Greenland Holdings under the guarantee. One is investment-grade, thanks to the guarantee, one is BB+. There is a differential between the two, but the key fundamentally is if you are raising capital for offshore projects you should raise it through the guarantee as you’ll get a better deal.
ALBERT YAU, CIFI: In our case it’s much simpler. Our holding company is a red-chip structure, domiciled in the Cayman Islands, so we don’t use the keepwell. But I still see further room in improving the funding costs, because by default all the domestic fundraisings have asset backing. Our offshore borrowings, including bonds and syndicated bank loans, are all on an unsecured basis. We definitely see the advantage of pushing down our bond issuance costs when we do more unsecured funding, so this is indeed one of the benchmarks we use when managing our finances.
IFR: So would you consider, if you were able, to issue secured deals overseas?
ALBERT YAU, CIFI: It’s a matter of cost. Truly, if it is very cheap, we would consider it, and indeed we have done one earlier this year. It offers us an advantage of about 160bp over unsecured offshore funding of a comparable maturity. In that case that’s worth doing. Overall, I think investors are definitely looking at issuers with less structural subordination. From the banks’ angle, they will be more willing to offer loans on an unsecured basis when they see the total proportion of unsecured funding is bigger. So I also see the better credits are moving in that direction. And again, as Wallace said, the other rating agencies have criteria based on the amount of assets being pledged. In our case, if we strive to transform 70% of our total debts to clean, unsecured debts, then we may be able to strike off the structural subordination. I do see comparable issuers without the bond rating notch down, and their bonds are performing better. So we are also moving in that direction.
IFR: Can we spend a bit of time talking about the Dim Sum market. Ben, you mentioned this as an area of interest. Is the convergence trade still valid?
BEN YUEN, BOCHK: In the long run that is still the direction. Right now it’s a two-tier market because of the capital controls. But once we have free flows in the future, it will become one market. That’s the trend. We have been in a transition period for the renminbi since the middle of 2010. If you look back to 2010, investors were in a hot market, they were eager to invest – not just from within Asia but from Europe as well. We launched one fund at my previous firm in 2010 with an average yield in the portfolio of less than 1%. Still people were investing, not because of the underlying yield but because of the expectation of RMB appreciation. Now if you look at the performance of the Dim Sum market in general, yields can easily exceed 4%. It’s a big difference from four years ago.
Demand is still quite strong from overseas investors. But the mentality has changed. As well as expecting appreciation they are looking at the yield, and it’s quite reasonable when you compare with the US or European investment-grade bond market. I can see demand will be ongoing, which should be good for the supply side, for issuers.
IFR: Is it fair to say Dim Sum investors are becoming more sophisticated as well?
BEN YUEN, BOCHK: Yes exactly. Back in 2010 there were not many choices. You can’t say anything was high yield in 2010, but now that more issuers are coming out and there is more demand, we are more selective where we invest. Let’s say in 2010 I had to buy around 80% of the issues in the market, now I have more choice. I can select maybe 50% of all the issuers in the Dim Sum universe.
IFR: I have an impression that when you look for overseas funding you would first try US dollars, with bigger sizes and longer tenors, and if that doesn’t work then you try CNH. Is that the way it works?
WALLACE LAM, HSBC: No I don’t think that’s fair. I think both markets have their merits. In my experience both markets work at the same time and they complement each other.
PATRICK LIU, UBS: I would agree with that. We might see an issuer do five-year dollars first, followed by three-year Dim Sum, but we also see the other way around. For some frequent issuers looking at their credit curve, perhaps three years is better than five, so a Dim Sum bond might be a better choice for them. There could also be a situation where it is better to do a Dim Sum bond than a US dollar bond because of changing exchange rates. The answer can be different because of market conditions.
IFR: If the Fed raised rates at its next meeting and the US dollar market froze, would the Dim Sum market stay open?
PATRICK LIU, UBS: Rates are going up; it’s only a matter of time. If you look at the volume in Dim Sum it’s mainly driven by investment-grade credits. High-yield credits represent only a small proportion of the market. Investors are under pressure to invest given their growth in AUM. In the dollar markets we can see the same situation where investors need to diversify portfolios away from overheated US and European high-yield into Asia. You can call it an Asia premium, a China premium, or a property premium for them to pick up in this market, but I think there will be demand there.
IFR: It used to be the case that high-yield covenants didn’t exist in Dim Sum. Is that changing?
PATRICK LIU, UBS: Yes. The recommendation we make to issuers is if you have dollar bonds and the covenants are there, then it’s easier to use the same package for the CNH investors. Two or three years ago, Dim Sum bonds had neither the proper high-yield covenants nor a rating. At that time, issuers and investors both viewed it as a small local currency market operating under its own dynamics. Now it’s become part of the global capital markets.
WALLACE LAM, HSBC: If you look at one issuer that has issued in dollars as well as in CNH, chances are the two documents would contain exactly the same covenant package.
KALAI PILLAY, FITCH RATINGS: They are using the same MTN programme and just changing the currency.
IFR: Is there still a way to reduce funding costs by targeting the private banks?
PATRICK LIU, UBS: Wealth management clients, by nature, are not so sensitive to pricing, so banks like ours may use that investor base as a key investor target for a deal. That strategy works really well for the high-yield names, because retail clients are chasing yield. For high-grade names I don’t feel retail clients contribute significantly to the book.
WALLACE LAM, HSBC: I would add that it’s a case by case basis. Some names actually if they’re household names that people recognise without doing that much credit work, that would probably appeal more to the private banking investor base. But if it’s a new industry or new name that retail investors haven’t heard of then it probably takes a bit more work.
BEN YUEN, BOCHK: Investment-grade Dim Sum bonds are not really in the private banking universe, but we have seen some good demand from regional pension funds, who are starting to consider Dim Sum bonds as an investment. We have never seen that before, only one or two were involved in 2012-13, but we see bigger pension funds coming into this market. They are quite restricted, usually to investment grade etc, but that is one of the trends for Dim Sum demand.
IFR: Kalai, are you seeing any difference in the people who approach you for CNH ratings now?
KALAI PILLAY, FITCH RATINGS: At the outset, quite often we don’t know what currency they’re going to issue, and again it goes back to the ability to price something at a certain time. That decision often comes after the rating process. Now for existing issuers to issue in CNH it’s very much a pricing discussion rather than anything else.
WALLACE LAM, HSBC: And how the swap market looks at the time. Some issuers may choose to swap the principal and interest into US dollars if the swap market is favourable, synthetically turning that into a dollar financing and saving money through the swap. But that’s down to the company’s view on CNH versus dollars and down to the swap market at the time. It’s really case by case.
IFR: Going back to fundamentals, then. Kalai, are you noticing any broad trend towards downgrades rather than upgrades for China corporate issuers?
KALAI PILLAY, FITCH RATINGS: It depends on the sector. Let’s start with property. Whilst it’s stable, it’s all fine tuning. There are companies that are outperforming the market and have better outlooks, and there we would change the outlook or move the rating up slightly. And then the reverse is also true. There are also companies that have surprised on the other side. They may have purchased too much land in 2013 that they are trying to digest in a tough market. Overall the sector is stable.
Now if you want to look a bit longer term, I would say some of the very large ones might start drifting upwards, as they become more efficient in a highly competitive market. At the same time at the very bottom, some just cannot keep up with that competition and will be falling off. You will see that polarisation continuing but it’s not going to be a rapid process.
IFR: We’ve been noticing a couple of overseas issuers that might default later this year.
KALAI PILLAY, FITCH RATINGS: Whether it’s this year or 2015 when the bonds are due, I think everyone has written them off. That’s the thing I want to make very clear. Even when there are defaults, it doesn’t mean that overall the whole sector is becoming weaker. It just means that some people had the wrong business model, or a model that looked good five years ago and is no longer viable in today’s market environment. If anything, the overall market has become a lot more disciplined compared to three to five years ago.
IFR: You could argue a couple of defaults would be a healthy thing.
KALAI PILLAY, FITCH RATINGS: I don’t know whether it’s healthy, but it’s the reality. And what I’ve learned in the Asian credit market is not to use one or two examples as your basis for predicting the future, because it’s all idiosyncratic. What I can say is that over the period of three or four years most market players have become much more disciplined. If you talk to investors you’ll hear them say that issuers are talking to them more and being much more transparent now. Our access to companies has gotten better.
In other sectors it’s tougher. For state-owned enterprises, there’s going to be some legacies from the communist era that have not been fixed, and you still don’t know what is the real core business in a conglomerate mishmash. But you’ll have very efficient state-owned enterprises coming to the bond market, too, so I can’t draw a common theme there. It’s going to be idiosyncratic. Metals and mining is a tough sector. There’s overcapacity in everything – steel, aluminium, whatever – and there it’s going to be tough for companies to recover. Some are doing fine, but you’re not going to expect rating improvement in that sector. We think we’ve done most of the downgrades there, but you never know how far it’s going to go, and there are still some negative outlooks in the sector.
Retail is another tough, tough environment right now. The anti-graft measures and preponderance of online shopping is really hurting them. Those are the two sectors where we feel there will be continued negative outlook, but there could also be companies that are able to withstand the challenges. Other than that, I think we have seen the bottom of the rating cycle for most sectors.
WALLACE LAM, HSBC: There’s a coal mining company called Hidili that has announced a partial tender for its bonds at below 70 cents on the dollar. That’s obviously a case where the company faced financing constraints. But if you look at the whole high-yield sector, you would expect to have some defaults. it is high yield, so there is a certain element of risk attached to it. The key fundamentally is that it could be very rewarding for people that do their homework and understand the company and the industry.
IFR: You do also have to deal with regulatory risk in these situations, where there might be a state-owned buyer or government strategy might suddenly change.
KALAI PILLAY, FITCH RATINGS: With a lot of these industrial sectors that is the challenge. You’re up against regulatory risks all the time. Getting approvals for some sort of expansion and then finding that those approvals are not really there. Those challenges are always there, and that’s part of the reason why some Chinese companies, despite having the same size and leverage ratios as their western counterparts, would be rated lower. It is a tough regulatory environment.
IFR: What about governance? Is that still a concern?
KALAI PILLAY, FITCH RATINGS: Governance is a very easy word to use, but a very difficult word to define. Over a period of time you have to ask yourself what exactly are the risks you’re talking about. Governance, again, is going to be idiosyncratic. You can never pick the next company which is a fraud – it could be anybody. But in sectors like property, companies have become so reliant on offshore funding, and if you want to fix the governance problem that really is the way. Companies will become addicted to the lower cost of funding, and they will open up and become more transparent.
MICHAEL LEE, GUANGZHOU R&F: We get calls at the end of every month from people asking what about our sales for that month. It’s a monthly thing. There’s so much data on the sector now, there’s so many checks and balances.
KALAI PILLAY, FITCH RATINGS: This is the good story that has come out of this whole experience, and I always point people to this. Four years ago if you asked a property company anything they would tell you to go away, but now they’ll say: “Here’s all my data, come and visit my projects!” They see the value in transparency, in getting the access to cheap capital that builds a bigger, more prosperous company. If you look at the industrial companies, that is the challenge now. Quite often we get very unique businesses, and it’s a challenge for us to understand them. Even when you think you do, you don’t really know if their answers are true.
IFR: You can only work with what’s in front of you, I suppose.
KALAI PILLAY, FITCH RATINGS: Exactly. But even there, many industrial companies with unique business models have withstood the challenges and have done well. We had that wave of high-yield issuers in 2010-11, and some have faltered, but many are still standing strong and starting to generate strong cash flows after putting the money in for capex. That’s true in the cement sector, for instance. You’ve seen West China Cement refinancing its bond at very attractive rates.
IFR: Ben, how much time do you spend trying to get familiar with management and governance issues?
BEN YUEN, BOCHK: We really focus on that type of question. When we put an issue in the portfolio our analysts are not only looking at the financial ratios of the company, but they’re also meeting with management to understand how they run the business.
IFR: Do you find you get the access you need?
BEN YUEN, BOCHK: Access is case by case, company by company. As Kalai mentioned, we don’t really have a definition of what good corporate governance means, but we can compare with different issuers to rank companies on our own radar. So to answer your question, yes we are very focused on governance issues. Another point on transparency is the reliability of the information as well. In the property sector it seems to be quite transparent from our point of view, because we can have weekly overall sales data, and we can monitor the market weekly.
WALLACE LAM, HSBC: When some of the companies came out with a quarterly newsletter that was already quite a big deal. Now we have monthly, and investors are demanding weekly!
BEN YUEN, BOCHK: I’m talking about overall data by city, rather than by company. The higher the transparency, the better for us.
ALBERT YAU, CIFI: Industry analysts collate weekly data and publish that themselves. We don’t report weekly, it’s all based on government registration data.
IFR: Governance is always a hot topic, but does anyone want to mention any other issues that we haven’t discussed?
WALLACE LAM, HSBC: There’s the question of whether we are facing any systemic risk for the whole sector. I think the government has been extremely good at putting out measures to mitigate that risk. For instance, the Rmb500bn liquidity injection in the five big state-owned banks is a very good example. At their disposal, they also have interest rates and capital reserve ratios in their arsenal, which the government hasn’t used.
IFR: Maybe if we had this conversation at the beginning of the year, the key question would be whether there is going to be a hard landing in China. Is that now off the table?
PATRICK LIU, UBS: Once the capital markets come to the conclusion that the property sector is a cyclical then you know there’s going to be an upturn and a downturn. If you recall, in 2009 all the bonds were trading at huge discounts without any default - people were simply scared about the whole sector. Since then, investors have matured and many now view a downturn as a good time to make an investment.
WALLACE LAM, HSBC: It’s also actually backed by fundamentals. If you look at the middle-income group that Albert mentioned earlier, there are 300m people in China who fit in that group. It’s doubled in the last 10 years and is probably going to double again in the next 10. Demand for housing for these middle-income people is going to be very strong.
IFR: From a portfolio manager’s point of view, do you still hedge against that type of tail risk?
BEN YUEN, BOCHK: Definitely we try to manage tail risks. One of the big differences between 2011 and now is that people viewed the systemic risk as higher in 2011. In the past three years the government has taken different types of adjustments to control shadow banking and local government debt. In general, that systematic risk seems lower today because of the higher transparency and also the direction of government policy. We can’t expect that one month or one year will be enough to sort out all of the problems, but this is the direction.
In terms of tail risks, from the data coming out now it seems things are deteriorating a bit so we have to be careful to monitor that kind of potential slowdown. But in general we think the systematic risk has improved a lot since 2011.
IFR: Before we wrap up this discussion, I’d like to ask our two issuers if there are any imminent plans to return to the offshore markets. Michael?
MICHAEL LEE, GUANGZHOU R&F: When Wallace said it takes two to tango, I think first of all investors need to be comfortable with the current market and with their exposures. There’s obviously some optimism, but there’s a fair amount of caution for the second half as a lot of developers are pushing out more volume.
On our side it’s a question of financing needs. If you’re not land banking then you’re refinancing; if you’re not refinancing then you’re terming out or lowering your cost of capital. So it depends on where the market is and where the pricing is, and is it attractive enough to make sense. I don’t think it’s a question of going just because the market’s there, because ultimately you still need to put that capital to good use. But after the financing activity in 2013 and this year so far, people are looking at the long-term view and asking what they can do to term out their profile. It’s not going to be a question of doing something just because the market opens, it’s a question of what is my use of proceeds and how do I apply those.
So for us, we always keep an eye on the market, we always see where pricing is and what investors’ appetite is, and then we make an assessment. But it’s not just a question of financing needs, it’s a rational decision of whether you need to do it, or whether it makes sense. It takes two to tango – now investors are still looking at the market, but I don’t think issuers need to come to the market. It’s a question of whether they have other options or other things they need to deal with.
IFR: I suppose a lot of companies have been in the market already this year, and there has been an opportunity to take some fairly cheap money off the table. Albert, is that true for you as well?
ALBERT YAU, CIFI: It’s almost the norm for real estate issuers to come out to the bond market at least once a year. Like our peers, we are trying to build out our own yield curve. The decision for fundraising in the bond market is basically driven by refinancing and new land banking. In our case – and we can see this from our peers as well – we are getting more prudent in terms of land banking because this year is a year of correction in China. It’s nothing new in our business; it’s come up every three to four years in the past 15 years. It has been very consistent.
When we are not in a new land banking mode then the issue volume depends on the refinancing. In our case most of the refinancing has been done early in the year. So never say never, we are always looking at the market and things can change very quickly, but we will look at financing once we have a need, and then we’ll chose the different type of market – Dim Sum versus US dollar, for instance, or from the bank market.
IFR: From the bankers’ point of view, is there a danger that companies could wait too long? The Fed is now talking about rates being at 3% by the end of next year.
PATRICK LIU, UBS: For highly-rated issuers it could be an issue. But for sub-investment grade issuers, the Fed is only going to raise rates when it feels overall markets are getting better so, in my view, the risk premium for a high-yield bond would be lower. I do not believe that there will be a rush for high-yield issuers to rush to tap the market just because rates are rising.
WALLACE LAM, HSBC: From our perspective, yes, rates are expected to go higher, but the rate at which they will go up is probably going to be very moderate. From the issuer’s perspective I would also add that if you are an investment-grade borrower looking at 200bp above the Treasury then any change in the underlying Treasury yield is going to affect the cost of borrowing, because it may constitiute a pretty significant portion of the borrowing cost. For high yield, or sub investment grade, the component that is correlated to the US Treasury may be relatively small. A lot of high yield companies are high growth, and if the return on that capital can yield 20% then a 50bp move in the Treasury yield doesn’t really affect the fundamentals all that much. What would affect the frequency of coming out to borrow is whether that investment will yield a very good return. If they’re not confident, or if the market is experiencing some volatility then they may actually come out less frequently.
IFR: Gentlemen, thank you all very much for your comments.
To see the digital version of this report, please click here.
To purchase printed copies or a PDF of this report, please email gloria.balbastro@thomsonreuters.com.
