What’s driving Chinese developers to issue onshore bonds?
Despite obstacles regarding eligibility and approval, China’s bond market has quickly gained favor among property developers this year, especially the smaller ones with speculative-grade ratings. Chinese developers are steadily tapping this market because it offers diversity and lower funding costs for weaker players.
What’s more, China’s property prices have bottomed out in the second quarter of this year, and market sentiment has improved since the downturn in 2014. We now forecast a 0%-5% rise in the average selling price and a 5%-10% increase in sales for 2015, compared with our previous expectation of flat growth or declines. Hence, many developers may soon need funding for expansion again.
How will the recent devaluation of the Rmb affect debt funding for Chinese developers?
We believe that this development will encourage Chinese developers to increasingly turn to renminbi financing over US dollar-denominated debt. This is because real funding costs for US dollar debt are likely to be higher due to the Rmb devaluation and the ongoing prospects for interest hikes by the US Federal Reserve. Therefore, we expect US dollar bond issuances from property developers to slow.
The Rmb devaluation is also negative for Chinese developers that hold existing US dollar debt. Chinese developers typically don't have any hedging against currency risk. Hence, we believe the recent Rmb devaluation will increase their debt burden in general. Nevertheless, the impact on their credit profiles is limited at this stage given the relatively low 3%-4% devaluation. Also, those with higher offshore debt exposure are generally the stronger players in the sector with more buffer.
What are the types of onshore bonds available?
Within China, there are two types of onshore issuances in separate markets. The interbank bond market (regulated by the People's Bank of China through the National Association of Financial Market Institutional Investors) accounts for the lion's share of the domestic bond market. We expect this market to deepen now that foreign central banks and sovereign wealth funds can buy bonds without approvals or quotas. The other bond market is on the Shanghai Exchange (regulated by the China Securities Regulatory Commission), although it is a smaller market.
Developers with a locally-listed platform generally issue what are known as "medium-term notes" in the interbank market. Other developers not listed in China, such as those incorporated in Hong Kong, are now also allowed to use their onshore platforms to issue "corporate bonds" in the Shanghai Exchange bond market. Therefore, all developers effectively gain access to domestic funding regardless of their corporate structure. However, those without a large onshore holding company for their various operating companies may find it more difficult to issue on a substantial scale. This is because issuance approvals are limited by the company's total asset size.
How do the terms and conditions of these onshore bonds differ from offshore bonds?
Although China ranks as the third-largest overall bond market in the world by volume, domestic bonds in China are underdeveloped in terms of issuance structure and the legal framework. Investors familiar with offshore issuances by Chinese corporates expect to find a typical package of financial covenants and negative covenants (preventing certain activities, unless agreed to by bondholders) that are aligned with global standards.
These covenants aim to protect investors by ensuring better repayment prospects via limits on debt increases, asset sales, cash distributions, mergers, and changes of control, among other scenarios. On the other hand, onshore bond documentation has some, albeit less-onerous, clauses such as asset pledge restrictions, additional debt incurrences on the same assets, and very broad event risks on earnings and cash flow. The clauses are relatively vague, and there are no change-of-control or cross-default clauses.
In addition, China's liquidation and insolvency frameworks are largely untested, with few cases of defaults in the public bond market. Some of the more significant distressed companies were rescued by the state through state-owned financial institutions and other conduits. Many investors continue to assume a high level of implicit support from the government. This is shown by the behavior of controlling shareholders and government interests in maintaining stability, although that is slowly changing. At the same time, credit risk pricing in the domestic bond market is less sophisticated, as shown in the narrower range of credit-rating and pricing differentiation.
What’s the significance of onshore bond issuances on the capital structures of developers?
So far, the recent onshore issuances have had little impact on the capital structures of our rated developers. Most of the issuances have been for refinancing onshore construction loans from banks and high-cost trust financing, and have effectively extended maturities and reduced average borrowing costs. The proportion of onshore debt hasn't changed significantly.
However, local bond issuance is generally positive for credit quality, largely because it provides another avenue for funding and has no foreign exchange risk. Over time, onshore issuance will improve capital structures and bond-structure protection. Bonds have the added flexibility of being unsecured and longer term compared to bank loans, which generally require asset pledges at the project level and repayments tied to construction completions. Moreover, smaller developers may tap the domestic bond market further as long as issuance costs remain lower, especially amid expectations of rising US interest rates.
Onshore bond interest payments are also tax deductible, while offshore bond interest payments are not.
We expect this local funding source to take up a more sizable portion of most speculative-grade developers' onshore debt, as long as it remains available. We believe the government won't close this channel for developers because its goal is to reduce corporate reliance on bank funding. At the same time, the government wants to develop China’s capital markets and move away from shadow-banking activities, such as trust financing and wealth-management products.
The author of this article is Hong Kong-based Senior Director of Corporate Ratings, Christopher Yip.
How would domestic issuance affect the developers' credit profiles?
This is a positive development overall. The impact is most pronounced on small or midsize developers that struggle with high funding costs and have more limited access to funding from banks and the offshore bond market.
These companies are likely to have used high-cost trust financing previously. The accessibility of domestic bonds will help ease their funding costs moderately. Although we don't expect developers' debt-servicing ability to improve considerably, the lower issuance costs could help provide them slightly more buffer against falling margins.
Bonds offer longer-term funding, which extends the developers' debt-maturity profiles and improves their liquidity positions. This is positive because refinancing risks and liquidity for many developers have deteriorated over the past year. Onshore bank loans are often short-term or tied to project completion schedules, leaving many developers with a large refinancing task each year. In our view, most Chinese developers have the ability to issue domestic bonds with maturities of up to five years--some even 10 years.
How would domestic issuance affect structural subordination of offshore bonds?
Domestic issuance will not have a substantial impact on structural subordination for offshore investors of rated developers. This is because we expect the proportion of onshore debt to remain largely unaffected. In addition, domestic issuances are unsecured, which means they will not create more asset claims. Structural subordination could improve if unsecured domestic bond funding replaces secured project loan funding at the project level.
Although both onshore and offshore bonds are unsecured and are theoretically equally ranked, differential treatment by the onshore legal framework may arise in the event of default. Investors offshore may also be left out of the negotiations happening onshore or be excluded from the borrowings assumed by an acquirer in a debt restructuring, as seen in the recent cases of Asia Aluminum Holdings Ltd. and FerroChina Ltd. Capital controls and legal enforceability could still place offshore investors at a disadvantage for recovery prospects.
In some cases, onshore creditors are favored in debt restructuring because issuers are more reliant on onshore creditors than offshore ones. For example, Kaisa Group Holdings Ltd. offered its onshore creditors substantially better terms than its offshore creditors. There is also a question as to whether a legal judgment by a foreign court for offshore bondholders would be enforced in China.
How would the reopening of onshore bond markets to developers affect offshore issuance?
We don't expect domestic bonds to substitute offshore issuance in the long term. About a dozen rated developers have issued a total of about Rmb70 billion of domestic bonds in the two onshore markets year-to-date. Together with rights issuance (when the equity window was momentarily accessible earlier this year), these funding actions have soaked up some of the financing needs from the offshore market for developers.
Although onshore issuance provides some diversification, the long-term availability of this funding tool depends on government policies. Onshore issuance is also currently subject to a longer and less-certain regulatory approval process, along with restrictions on issuance amount. In contrast, offshore bonds issuance has fewer such restrictions and is an efficient, well-established process widely accepted by investors.
Although the demand for refinancing of offshore notes in 2015 is relatively light, it will increase steadily over the next three years. We continue to expect Chinese developers to refinance maturing notes offshore given that these notes' individual issue sizes tend to be substantially larger than what domestic bond issuances have been able to achieve.
The author of this article is Hong Kong-based Senior Director of Corporate Ratings, Christopher Yip.