Yield is king in China’s ‘dim sum’ offshore yuan bond markets

March 21, 2013


A return to China’s offshore yuan bond markets, or “dim sum” as they are colorfully known in Hong Kong, may be sweet for Gemdale, a mainland property developer. But not all fund managers are smiling. The company raised five-year money at 5.63% amounting to 2 billion yuan. Not bad, considering that last July, it raised a lesser sum for a shorter tenor while coughing up nearly double of what it paid this time around. Add the fact that it did so by keeping to the same weak bond covenant and Gemdale seems to have pulled off a stunner.

But Gemdale doesn’t seem to be the only one. In recent days, issuers with weak bond covenants have discovered a ready market for their debt and at much cheaper rates. In theory, bond covenants can be divided into two halves: affirmative and negative ones. The former promises to pay bond holders on time while the latter forbids it from exceeding certain financial ratios such as interest paid/EBITDA, debt to equity, etc. And of course, they are secured by the company’s assets or backed by bank guarantees or letters of credit

But when theory meets reality (read: offshore hunger for yield meets hungry onshore Chinese issuers), financial “creativity” is the outcome. So mainland companies set up complicated structures to ensure they are able to keep regulators and ratings agencies happy while getting access to cheap capital quickly without having to negotiate labyrinthine approvals processes.

And has that system thrived. Fidelity Investments says Chinese offshore bond issuance is the fastest growing sub-set of the greater Asian dollar and the dim sum bond markets. Offshore issuance by Chinese companies in both the dollar and the offshore RMB markets have boomed over the last two years and the fund manager says 16 companies amounting to USD 9 billion have such structures.

Enter keepwell agreements. In Moody’s words,  they are used by China-incorporated companies to support offshore subsidiaries issuing debt. Unlike guarantee structures, a keepwell structure requires no onshore regulatory approval. (emphasis added) The agency has rated 19 bonds from 13 Chinese issuers totaling over $9.4 billion using these credit-enhancement structures.

Put simply, as these bonds are issued by offshore subsidiaries, bond holders have no direct recourse to the onshore company. All they can hope for is that the onshore firm will keep in mind the foreign creditors if there is a credit event. Of course, these structures haven’t been tested yet so investors aren’t sure on how things would unfold in practice.

While rating agencies rate these offerings at a marginally lower level than the onshore companies, that hasn’t stopped fund managers from lining up to vote with their wallets. Gemdale’s offering, for example, saw its order book stretching out to 8 billion yuan from 122 investor accounts. Fund and asset managers took 72 percent of the deal, followed by private banks at 16 percent and banks at 9 percent.

While weak covenants may be overlooked by investors as long as the yield is juicy enough in this age of zero interest rates, a credit event is all it may take for dim sum bonds to upset investors’ stomachs.

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