Onshore bonds: cracks appear for property groups

They have all been heading to the newly opened-up onshore bond market. But could some Chinese property issuers be tempted offshore again as they reach their domestic credit limits, investors start showing signs of fatigue and the spread differential between the two markets narrows?

That is certainly the view of Arthur Lau, head of Asian fixed income at PineBridge Investment in Hong Kong. 

He believes the offshore market is starting to become a more cost effective option again even on an after-swap basis, although it is never likely to reach the heights it did at its peak in 2014 when Chinese property developers raised $21.64 billion in the G3 bond markets according to Dealogic figures.

If he is right, it will be particularly welcome news for the international investment banks whose fee income has been decimated by the developers’ recent migration to China’s domestic bond market.

In 2014, Dealogic figures show that Chinese property developers accounted for 44% of the $25.86 billion raised by Asian ex-Japan high yield bond issuers in G3 bonds - always the most lucrative segment of Asian debt capital markets.

In 2015, the percentage rose to 61%, but only because issuance volumes dropped off a cliff after the Indonesian high yield market shut down and Chinese property developers headed onshore in every increasing numbers from July onwards. Developers with high yield ratings raised just $6.93 billion offshore in 2015, down from $11.48 billion the year before.

Source: Dealogic

The opening up of China’s Rmb 48 trillion ($7.3 trillion) domestic bond market was arguably the biggest theme in Asian debt capital markets last year, if not over the past decade. Simplifying the issuance process so companies could apply directly for stock exchange approval opened the floodgates in the summer.

Evergrande led the charge when it raised a hefty Rmb15 billion ($2.3 billion) from a twin tranche issue in mid-June. By the end of 2015, Chinese property companies had raised a total of Rmb236 billion ($36.24 billion) onshore according to Moody’s, 20 times the 2014 level.

Source: Dealogic

It completely changed the dynamics of the offshore market, in which participants had spent the first half of the year worrying about overleveraged balance sheets and re-payment issues following problems at Shenzhen-based Kaisa, which became the first company to default on its offshore debt after some of its projects were frozen during a corruption probe.

The second half of 2015 ended up proving a win-win scenario for both issuers and investors. For issuers, the domestic bond market gave them a new source of funding and also a much cheaper one thanks to China’s low domestic interest rates and elevated demand from domestic investors looking for bond market opportunities after the stock market crashed in the summer.

One of the best examples of this dynamic in action comes from Hong Kong-listed Times Properties whose senor unsecured dollar-denominated debt is rated B2/B+/B by the three international agencies. In March 2015, the company raised $280 million from the international bond markets, but had to pay an 11.4% double-digit coupon for a five-year bond with a three-year call option.

In July it issued its first domestic bond. This comprised an Rmb2 billion five-year offering with a three-year step up on a 6.75% coupon. At the time its international bond was yielding 12.16%, a 541bp differential.

However, this yield gap also generated a windfall for investors during the second half of the year.  Offshore spreads started tightening as investors became conscious new offshore supply was drying up and they no longer had the pricing power.

“International investors started to take comfort from property developers' access to alternative funding sources to manage their liquidity and operations despite the potental for greater offshore subordination,” said Ethan Farbman, a managing director in Morgan Stanley’s debt capital markets team.

Indeed in the event of a restructuring, onshore investors typically get first claim over a company's assets and cash flows. As a result, rating agencies notch down international bond ratings once onshore debt to total assets hits a certain limit. 

By mid-December the yield on Times Properties' March 2020 bond had shrunk to the 9.6% level, a tightening of just over 200bp. This made Chinese high yield property bonds Asia’s best performing asset class during 2015, with the iBoxx US dollar-denominated China Real Estate Index returning 16.4%.

Julian Trott

“If you were long high-yield Chinese property bonds you would have done very well in 2015,” commented Julian Trott, head of Asian debt syndicate at Goldman Sachs. “By contrast, the US high yield market was much more challenging given its high percentage of oil and gas names and the sell-off in the commodity markets generally.”

This winning streak has continued into 2016. As of March 29, the yield on Times Properties March 2020 bonds was around 8.3%, a further 130bp tighter since the end of the year.

However, the opposite dynamic has been at work in the onshore market. The lack of active secondary market trading there makes benchmarking more difficult, although the advent of more international investors may start to change that following the government’s decision to scrap its quota system in late February. 

But issuance activity in the primary market shows Times Property is now have to pay a lot more and on shorter tenors to raise debt domestically. In January, for example, it raised Rmb3 billion from a three-year bond with a two-year call option. This deal was two-years shorter than its July 2015 offering, but the 7.88% coupon was 113bp higher.

This means there is now a roughly 50bp yield differential between its onshore and offshore bond curves compared to 500bp at its peak last year. Issuers, investors and investment bankers are all now calculating how this trend will play itself out.

Clearly China’s domestic bond market, the world’s third largest in terms of outstandings, is here to stay and not before time given the size of China’s economy. For an issuer’s perspective it is nearly always more advantageous to fund in their home currency to mitigate FX risk. Interest income is also tax deductible on domestic bonds in China, a further positive.

As a result, record levels of onshore issuance have continued apace. In January, Chinese property developers raised Rmb38.7 billion ($5.94 billion) according to Bank of China figures, five times more than they did in 2015.

In February they raised a staggering Rmb68.1 billion ($10.43 billion), a new monthly record.

But there are signs the onshore market is suffering some indigestion where some lower rated names are concerned. 

“Some of the higher yielding credits are likely to start coming offshore again, as onshore investors are increasingly putting more focus on credit quality,” explained Paul Au, co-head of Asian credit market syndicate at UBS. “They’re no longer getting the tenors they require onshore and there’s almost always a bid for them offshore at the right market clearing price, which isn’t necessarily the case onshore.”

Two further factors will be key. Firstly, some property companies are reaching their onshore borrowing limits.

Terence Chia

“Issuers are capped at a borrowing limit of 40% of their Net Asset Value onshore,” stated Terence Chia, head of Asian debt syndicate at Credit Suisse. “Once they reach this cap, they may venture offshore again where there’s no such regulatory limit, although they’ll need to be conscious of their debt headroom ceiling bound by covenants and ratings triggers.”

Secondly and most importantly will be the Rmb’s performance. If it shows signs of stabilizing, some offshore borrowers may return to the dollar market and international investors may also start positioning themselves in the dim sum (CNH) market again.

“We view the current median 9% to 10% yield on CNH property universe as attractive if the Rmb continues to stabilize,” BOCI credit wrote in its monthly property credit update at the end of February.

Shrinking pool of dollar bonds

So far in 2016, there have been four offshore issues: a $700 million dual tranche offering by Evergrande, a $150 million issue for Hsin Chong Construction, plus two private placements: a $260 million four-year issue by Logan Properties and a $500 million perpetual by Jinmao.

In total, the quarter raised $1.61 billion. But net issuance is still just in the minus figures thanks to heavy redemptions, as developers use their new onshore proceeds to repay more expensive offshore debt.

In January, Sunac called its $400 million 2017 bond, while China SCE called its $350 million 2017 bond, Powerlong its $250 million 2018 bond and Future Land its $200 million 2018 bond.

Then in February, Aoyuan called its $112.5 million 2017 bond and Hopson announced it was calling its $300 million 2018 bond.

In March, China South City said it was calling its $125 million 2017 bond early, while CIFI Holdings announced it was redeeming its $500 million April 2018 bonds.

Together they have removed $2.24 billion of paper from the market. JP Morgan credit analysts estimate redemptions could hit $15.7 billion this year, up from $6.307 billion in 2015.

However, the peak year is likely to be 2017 when the wave of bonds issued in 2014 can be called. The US investment bank forecasts redemptions could peak at $20.5 billion. 

The pool of outstanding Chinese property bonds has, therefore, started shrinking from its estimated $55 billion total. When 2015’s redemptions are taken into consideration, net issuance last year was only $4.4 billion.

Source: Dealogic

Power dynamic shifts to issuers

This means there is a very strong technical factor underpinning current spread levels even though investors know they are unlikely to enjoy the same spread performance in 2016 as they did in 2015. 

But it also creates something of a quandary. Having put in the necessary credit work, international fund managers like the dollar-denominated property sector because it offers a good yield pick-up in a low interest rate environment and provides a liquid pool to trade in and out of.

By contrast, even though they know the domestic market is where they will need to be in the future, many do not yet have access to it. Those who do have quotas are not keen on the fact that spreads are tight, liquidity is even poorer than international markets and credit analysis is still low.

This has left the power dynamic between issuers and offshore investors very clearly in the hands of the former. As a result, even some of the lowest rated companies have been able to weaken the covenants on their dollar-denominated high yield bonds.

In February, for example, Evergrande successfully sought investors’ consent to amend the terms of its $1.5 billion 8.75% 2018 notes and $1 billion 12% 2020 notes, loosening restrictions on its ability to raise more debt.

The event was described as credit negative by S&P. The B2/B+/BB- rated group is currently on negative outlook from all three international agencies on the grounds that has no more room to expand leverage within its current ratings bracket.

In March, China South City has followed suit with a bid to amend the indentures of its $400 million 2019 bond. 

Declining ratings

Indeed, bankers and credit analysts are quick to point out the sector’s overall leverage has only been declining very slowly. Many of the broad credit risks have not fundamentally changed even though the underlying business environment is improving, with average selling prices starting to tick up in tier 1 and 2 cities and the inventory backlog declining in tier 3 cities.

While spreads may be tightening, ratings are generally on a downward trend. A number of companies are also in danger of crossing over from investment grade to high yield status. One particularly large “fallen angel”, as BOCI credit research puts it, is Dalian Wanda.

The company’s transformation to an asset-light model saw Standard & Poor’s downgrade it from BBB+ to BBB on February 2. At the end of last month, Moody’s also put Beijing Capital’s Baa2 issuer rating and Agile Properties B1 senior unsecured ratings on review for downgrade as well.

Greenland Holding’s Baa3/BBB-/BBB- ratings are also all on negative outlook, while Standard & Poor’s changed Sino-Ocean Land’s BBB- rating outlook from stable to negative in mid-February and Yuexui's BBB- rating to negative in late March.

The agencies are also watching for signs of re-payment stress because of FX risk, although all three point out that re-financing with onshore debt is mitigating this. In February, Moody’s said the companies it rates could withstand 10% depreciation within their current ratings bracket.

Key man risk

The biggest minefield over the past year has been headline risk, the almost unquantifiable possibility that one or more of company’s leading officials may be pulled in under Xi Jinping’s anti-corruption campaign. “Headline risks are inherent part of the Asian credit universe,” said UBS’s Au."One way to manage this is by having diversification across a portfolio."

Campaign: Xi Jinping

But bankers agree the Chinese government seems to be more conscious of minimizing the impact on an individual company’s day-to-day business, They also believe market participants are also starting to take headline risk more in their stride.

Kaisa and Agile’s personnel-related problems impacted their bonds for months. But when Future Land’s chairman, Wang Zhenhua, was taken in for questioning in late January, the company’s bonds dropped just one point. Officials were quick to swing into damage limitation mode via a series of investor conference calls.

Likewise on February 11, China Jinmao announced that its new chairman, Cai Xiyou, had taken in for questioning. The company’s 5.75% 2021 bond also dropped one point in price terms, then stabilized. 

“One thing, which has changed is the amount of due diligence we’re required to do on property companies before we can underwrite their deals,” one banker remarked. “It’s not just a matter of wearing a yellow helmet and going on a site visit. The level of checks goes right down into the legality of how they acquired their land banks in the first place.”

Bankers also say offshore investors have become more aware of their uncertain legal status in the event of a potential restructuring. “There’s a substantial gap between where Kaisa’s bonds should be trading and where they are trading,” one banker argued. “That gap reflects the weak legal and negotiating position investors felt they were placed in.”

Yet bankers agree that investors’ appetite for new dollar-denominated issues remains undimmed. Key will be where issuers do come back, whether that be for diversification purposes, to fund overseas acquisitions or more simply because the offshore market has become more cost effective at a time when the onshore market is reaching its limits. 

“Investors are definitely keen to put money to work and Chinese property is still one of their favourite sectors because of the yield pick-up,” Chia concluded. "But with markets remaining volatile, timing will as ever be the key to success.”