Real estate dominates China HY but regulation hurdles loom

 

Participants in the roundtable were:

Eugene Fung, head of credit investments, BFAM Partners

Shaw Yann Ho, head of Asian credit, JP Morgan Asset Management

Wilson Li, chief operating officer and chief financial officer, Car Inc

Gerhard Radtke, counsel, Davis Polk & Wardwell

Douglas Sung, chief financial officer, Shui On
Fred Teng, executive director, head of high yield product group, debt capital markets, Greater China capital markets, Standard Chartered
Albert Yau, chief financial officer, CIFI
Paolo Danese, moderator, GlobalCapital

Global Capital: What has been driving the buoyant Greater China high yield market?

Fred Teng, Standard Chartered: There’s a cyclical aspect to the supply — 2017 was always expected to be a busy year. There is $27bn-plus of refinancing from maturities and bonds callable this year. Five years ago coupons were 12%-plus and now we’re talking 5% so naturally it is an amazing opportunity to refinance. Next year is frontloaded as well, we’re talking about another $20bn-plus, the majority of which will be in the first half of 2018. 

But the regulatory environment has had an impact on the offshore market. The slowdown in 2015 and the first half of last year was because of the liberalisation of the onshore market. 

Most Chinese issuers have renminbi revenues, so there is a natural attraction to borrow in RMB to reduce FX exposure. Issuers were naturally attracted to the onshore market when it was available for them.

From the middle of last year they tightened up regulations for real estate sector issuance onshore and everyone had to come back offshore to issue bonds. However, this past quarter there has again been some tightening up, with NDRC [the National Development and Reform Commission] slowing approvals for new offshore issues.

The other theme for HY is supply from non-real estate sector issuers. The Chinese market has matured. Five years ago you would not have had non-real estate companies doing M&A in the volume and size that we’re seeing right now. I’m talking about the private sector, not state-owned enterprises doing multi-billion dollar deals. And this will stay on for the next five to 10 years at least. Additionally, the One Belt One Road initiative will have an impact on supply as China reaches out to its partners in the OBOR region. 

I expect the power sector or sectors related to infrastructure to be doing more investments in these countries and, therefore, also increasing their needs for offshore financing. In terms of diversity, looking back maybe five, six years ago you’re talking about more of an 80%-90% market share for real estate, but I think that has shrunk to maybe 60%-70%.

Eugene Fung, BFAM Partners: On the non-real estate side there are definitely industrial names that are interesting. Diversification is good but I do think the process is important. For some industrial names we can do proper due diligence for an initial issue, but there are others that come across as somewhat fly-by-night.

And then you see conglomerates which recently have expanded into real estate, they’ve gone into banking, they’ve gone into asset management and they do a deal every other week. Diversification generally is taken as positive, but in this case it’s more of a mixed bag.

Shaw Yann Ho, JP Morgan Asset Management: On the surface there is diversification, but in reality the investable universe is still quite limited to some repeated real estate names. For example, there are some consumer sector names that have come to the market, but, as you know, the quality control in terms of food and drugs is not something that is very visible to us. Even if they are offering a much more attractive yield compared to the traditional real estate players, we are not that comfortable going down the credit curve for some of these debut consumer names.

And we have to be very careful whether they are in an industry that is going to be consolidated or where they are going to be the consolidator. If they are going to be the former then the control is going to be limited. So even if they offer 8%-9% it’s not something that you could readily jump on. You can see 100 names in the market, but I think the investable ones are only 50 names.

GlobalCapital: Gerhard, what other supply themes are worth underlining?
Gerhard Radtke, Davis Polk & Wardwell: The high yield flow has always been very volatile: everybody rushes in or everybody waits. And the drivers have been different over time — macro trends in specific industries, whether cement at one point or natural resources at another, or FX and yield expectations and differentials between onshore and offshore. 

But first and foremost, I think supply has been driven by regulatory matters, particularly the ability of issuers in certain industries to access the onshore bond and loan markets. That has had a fundamental impact, shutting down markets for years at certain points in time and constraining supply from entire sectors, if they can borrow cheaply onshore instead of offshore.

In the recent past there’s the ability, for example, of A-share listed companies, and more recently even onshore privately held companies, to tap the offshore market. That may be a game-changer, because the potential pool of candidates from that space is almost infinite. So far, it seems that if you are from those segments, to go to the global markets you still need to explain why you’re seeking international exposure, but I think over time the requirement for that linkage may shrink. Comparing this year to previous years, the ability of A-share companies to access the market and onshore the proceeds has created a tremendous diversification of names, even to niche players in industries where typically people would have found it very difficult to put the story together.

Teng, Standard Chartered: We did a debut bond deal late last year for Shandong Ruyi. This is a private company in China, bond rating of B3/B-, with Standard Chartered acting as the sole global co-ordinator. That deal showed how far this market has come. We do have sophisticated, deep-pocket, buy-and-hold investors in our region and when given enough time to do their work properly, subject to the right covenant package, they can support and anchor transactions.

Ruyi is a very interesting textile company that is vertically integrated with assets overseas. They own retail assets in Japan, they own sheep farms in Australia, and also recently bought a retail fashion brand called SMCP in France. They would probably have been too low rated to access the market a few years ago.

Ho, JPM AM: I think different investors are also at different stages of maturity. There are mature investors who have been in the market for the past 10 or 20 years, but then we have seen in the last five years a few Chinese asset managers coming to Hong Kong, setting up shop, and investing in high yield names in US dollars. They have plenty of liquidity on the book and they are pretty eager to invest that liquidity.

I think different levels of hunger cause investors to view valuations with very different perspectives, so certain issuers take the opportunity to issue something that they might not have thought of three years ago.

GlobalCapital: Issuers: coupons have come down, regulation has broadly made it easier to tap the offshore market. What other factors have pushed you to the offshore bond market?

Wilson Li, Car Inc: We are quite different from state-owned enterprises, the government platforms, or the CREs [commercial real estate companies]. They don’t have any issues financing offshore with their credit profiles. If you just look at interest rates, the onshore market is more attractive. If you also consider FX, onshore loans make more sense. When we raise funds, we typically use the majority of proceeds onshore. In the future there is a potential for other needs, such as M&A and global business expansion. But that is not a core use of proceeds at the moment, it would be funded more ad hoc.

Albert Yau, CIFI: When our company went public in 2012, for the first two years our demand for offshore funding from the bond market was strong. At that time we compared offshore bond issues to non-bank financing in China, like trust loans and special loans from funds. Dollar funding, even at around 10%-plus, was still cheaper than the alternative sources of financing in China. Things have changed since two years ago, when the renminbi currency reform was announced in the third quarter of 2015. It was a game changer: it meant dollar debt would in fact have a negative P&L effect.

Plus, the onshore bond market was opening up for developers so we had a cheaper choice. Most developers became less keen to look at dollar funding, except for refinancing. The other constraint right now is the NDRC filing, which has been in place since the second quarter of last year. We need to complete the filing process at the city or provincial level, and at the national level for the NDRC. Right now most issuers with a corporate structure like ours are more driven by the NDRC filing requirement rather than their own needs. Once you receive an issue quota then somehow you have to get it done before its expiry date.

But we feel happy that we in the past two years have restructured our liabilities to have a very good balance between onshore and offshore debt. Offshore accounts for around 40% of the total. And we haven’t really relied on offshore funding for capex for the past two years, so right now that’s more for refinancing.

Douglas Sung, Shui On: We are not bound by NDRC filing because we are an offshore entity and the majority shareholder is not a mainland citizen. We can go out to the market at any time — it is a market rather than regulatory-driven decision. But the key thing for us to consider is really the forex impact. Ultimately our revenue is in renminbi and in the long run it is not desirable to have a lot of funding from offshore. So we have been trying to rebalance it in the last few years. We have reduced our FX exposure so that roughly 40% of our borrowings are in FX right now, quite similar to CIFI, but we want to reduce it a bit further if possible and maybe bring it to 30% or less. I think that would be more sustainable because ultimately you cannot count on hedging to reduce that FX risk, as hedging is too expensive and it’s too volatile.

The key decision for us right now is how we see the RMB moving, given the potential additional hedging cost to issue in dollars. While the coupon is 5%, 6% we probably need to tack in another 2%, 2.5% of hedging costs, and then it’s actually not that attractive.

Li, Car Inc: The simpler route is just to go onshore and take renminbi via bank loans or bonds rather than going offshore. We are not that keen to tap into the dollar market, especially in this kind of environment. It also depends on the stage of the company. Back in 2015 one factor was broadening funding sources for the long run. Some companies without international ratings tried to open that up. We made the effort to get an international rating and build our credit profile to maintain relationships for the long run. Then the environment changed, including with the renminbi depreciation. Looking back today, financially it was not so wise to get huge dollar liabilities at the time, but it was a good step to open up more options. 

Looking at the last 12-24 months, the major change that has affected funding decisions is FX. If the RMB becomes more stabilised or hedging costs fall then it will make more sense to go offshore. But it also really depends on onshore interest rates and liquidity of the market, especially given the recent tightening. Last but not least, it is about our own situation. We do need offshore money but today onshore to offshore capital movement is not easy. If you have to do something offshore or even an onshore acquisition via an offshore structure, then you need the capability to fund offshore.

GlobalCapital: Going back to the investors: what have falling coupons meant for your investment decisions, now that spreads to investment grade are much smaller?

Fung, BFAM Partners: I don’t look at it as a spread versus investment grade. It is an investment decision for us to stay away from crowded trades and to find unusual value. Our fund has been one of the biggest proponents of Chinese property high yield. In particular because it is so cheap, since the traditional business model for CREs has been to raise offshore debt and use the money to fund land purchases. But sellside credit analysts do not like that model and always write negatively about it, they’ve always been kind of allergic to it. 

Instead, we find the real estate sector to be a good opportunity. First, because we don’t think the government will ever upset the apple cart. Second, because we find that it’s much easier to track these firms since the assets are actually hard assets, versus forestry assets or a fishing licence, for example.

So if it is structurally cheap versus its rating that’s super-attractive. We had a lot of these bonds with 12%, 13%, 13.5% coupons sitting on our books until, starting about a year ago, they started getting called away. We did and continue to participate in a lot of refinancings, but I don’t think the sector is structurally cheap any more. All the naysayers now have actually left the sector because shorting Chinese property bonds doesn’t really pay.What that does is force us to see this sector as just market weight, versus being overweight as before in our deployment of capital. Because we look at things from a total return after leverage perspective, the good thing is that since the performance of the bonds has also increased, the return on capital does not necessarily change our decision that much on what to invest in.

But for these high yield bonds that are now priced for perfection any slip-up is going to cause a very severe drop. It doesn’t matter whether you’re in commodities, in property, or in telecoms, that’s the risk you run if your buyer is becoming more levered. I’m also very cognisant of the fact that we are no longer the price setters. There are these China AMCs [asset management companies] that come in and do their own leveraged carry trade; they raise money through dollar bond issues, they buy high yield bonds, they take it to the offshore banks and lever themselves up even more.

But that’s the market, I think you have to respect that. Whereas we were predominantly Chinese property maybe two/three years ago, now it’s a lesser component of our book and we are a lot more discerning.

Ho, JPM AM: We diversified away from Chinese-only real estate investments and that’s because we are index-driven investors. We are not only looking at maximising total return without also locking down on the risk management profile.

Having said that, there are different ways of diversifying away from Chinese real estate, because currently the spread is at 300bp over the typical five year or three year US Treasury level. For this kind of pricing, it’s not difficult to find substitutes. There is tier one paper coming out from strong banks in the region that is already spreading at the 250bp-300bp level. To me a strong bank that has got implicit government support, I feel that the slippage in paying coupons and not having the right capital buffer could be quite minimal. 

Also, because the spread is at an all-time low, to beat the index I think having the duration call right is more important than the spread call. So we are not gung-ho to push ourselves to the widest spread possible. In fact, we are trying to balance ourselves between a duration play and a credit spread play.

GlobalCapital: Back to the NDRC rules. Albert, you’ve given us some general idea about what that process entails, can you go into more detail?

Yau, CIFI: The rules generally affect the Chinese issuers even when they have a Cayman Islands or Hong Kong structure, and those whose major shareholder is a Chinese national. So they obviously won’t hit companies like Shui On or a couple of other Chinese developers if their major shareholder was clearly an overseas national at the time of establishment.

But most real estate issuers from China fall under these rules. We need to complete the filing process from the national NDRC to get the suitable PRC legal opinion for the issue. As for how long that takes, like every other filing or approval process in the China capital markets, it’s difficult to gauge — it fluctuates.

Sometimes for certain industries it seems easier to get approvals and sometimes it is less so. If you look at the bonds by China real estate issuers this year, most of us are using quotas that were applied for last year. In 2016 it tended to be quite predictable, this year the process tends to be lengthier.

Fung, BFAM Partners: Do they co-ordinate with the FX side of things? And for maturing bonds, what if NDRC approval is not coming and you have cash onshore to redeem but you’re not allowed to take the cash offshore? Do you see that as a technical pothole issuers can potentially fall into?

Yau, CIFI: We understand the process is strictly within NDRC. Of course, when the original circular was issued last year they could have been coming from the FX perspective, I think they still are. As for liquidity and servicing offshore debt, generally the NDRC also focuses on the use of proceeds. Last year a lot of the quota approvals were on the basis of refinancing, but this year it seems the approval is based on multiple factors, not just refinancing. Risk-wise, NDRC and, in the case of onshore bonds, CSRC [the China Securities Regulatory Commission] have never actually missed approvals in terms of timing for refinancing need, so we are not too concerned about whether there will be a systematic problem with issuers not being able to get quotas in time for refinancing.

What remains difficult is to move proceeds from onshore to offshore to repay debt, otherwise we would have done that last year, since the liquidity was just so abundant. We could have paid down all the US dollar debt if it could be achieved, but I think in the near term this is not feasible, unfortunately.

Ho, JPM AM: Have they clamped down on the Nei Bao Wai Dai [offshore loans for PRC firms] procedures?

Yau, CIFI: We never think there is clampdown, it is ‘window guidance’ in China. The policy facilitates all sorts of free flow of capital. Right now we have different sources including the cross-border cash pools, which have been established by most large corporates. And then we have channels like the Nei Bao Wai Dai, and that’s always possible. We also have the freedom of reusing capital from proceeds of offshore-invested real estate projects. Administrative measures always change, sometimes flow of capital is easy, and sometimes it is not. There are overall quotas and limits at the time of implementation for every channel.

Ho, JPM AM: Fred, if Nei Bao Wai Dai is still possible why is there such a lack of these deals?

Teng, Standard Chartered: When you operate a business in China you are subjected to regulatory uncertainty. To be successful long term you do need a good bank, a good partner bank that is able to be there for you when you need them. A bank that can execute bond deals offshore and onshore, as well as provide balance sheet support.

Sung, Shui On: My sense is that a lot of issuers, Chinese developers or likewise, have credit facilities outside the bond market in the banking system, for example, to get corporate loans to patch up the gaps. I think a significant credit event seems unlikely at this stage because the offshore market is still very liquid. Systematic risk seems unlikely at this stage unless there is a big fallout in the offshore market.

Radtke, Davis Polk & Wardwell: We would like to see the regulatory process become steadier, so as to avoid swings between very constrained supply at one time and then a supply burst at another. That is unfortunately what we saw late last year, when uncertainty as to whether last year’s approvals could be utilised this year meant a rush to market before calendar year end. Then there was relief because it was established that these approvals could be carried forward for some time.  

At the moment, NDRC approvals are not so easily forthcoming and the number of issuers affected seems to be quite large — perhaps in the triple digits. Which raises the question, if the current policy decisions result in new approvals, will there be another supply burst? That would be unfortunate for the market. Ideally, we would have a more reliable and more transparent process, in which the decision to access markets was solely based on capital structure optimisation, rather than regulatory cycles.

The SAFE [State Administration of Foreign Exchange] perspective is also important, in particular for onshore issuers, meaning PRC A-share-listed companies or issues that are guaranteed by a PRC parent. SAFE regulates the onshoring of funds, and while this is in technical detail still as complex as Albert explained, there has been significant progress. At least now it is feasible for an onshore issuer to guarantee debt raised by an offshore SPV and then to onshore the funds.

The framework for that has significantly improved, with a big improvement early this year and big steps taken last year. Overall, the regulatory environment is developing and that has led to more issuers and overall bigger volumes. But questions remain, for example, as to whether a particular offshore issuer actually needs NDRC approval, since it can be very difficult to determine whether the offshore issuer is controlled by a PRC entity or resident. There are clear cases where an issuer certainly doesn’t need any NDRC approval, but there are a lot of borderline cases that are very difficult to assess without consulting with NDRC.

Fung, BFAM Partners: But whose responsibility is it? Is it the company’s own determination? The underwriter’s? Who’s on the hook?

Teng, Standard Chartered: I think it’s everyone’s responsibility, really. If we, as underwriters, are not comfortable in our level of due diligence with regard to this policy, one day we could be penalised by the regulators, and I think it is the same situation for legal counsels and auditors. Issuers could get into difficult situations too, for example, if they are denied access to the bond markets in the future. Investors would end up holding bonds of an issuer with a weaker credit profile. So these are risks that are going to be borne ultimately by all participants.

GlobalCapital: We’ve mentioned the new Chinese players coming into the market, both as underwriters on the deals and investors. How has that changed the picture for foreign banks?

Teng, Standard Chartered: There have been recent examples where these deals underperformed the market. I think it is up to the investor base to self-police this aspect, to look at who are the lead managers for these deals. We have seen numerous examples where deals are done in circumstances where Standard Chartered would not be comfortable in participating.

We could be talking about inadequate levels of due diligence, for example. Is the due diligence scope enough for us to put our hand on our heart to say we know this company, we know what we’re selling? When major banks decline to participate, investors should try and find out why.

We have also seen other off-market practices such as aggressive timetables closer to blackout periods, off-market standards in covenants, where some terms could actually threaten the whole concept of the covenant package, and aggressive interpretation of regulatory requirements, where certain banks have been more liberal in their interpretation of whether a filing or a registration is required. These are some of the issues we have encountered, and definitely more so in the last 12 months than ever before.

GlobalCapital: Gerhard, are due diligence standards dropping?

Radtke, Davis Polk & Wardwell: Due diligence is an important and sensitive topic, but it is always situation and fact-specific. The market has a large continuum from private placements at one end to deals that are widely marketed globally at the other end, and different execution styles are necessary and suitable for that wide spectrum. The important thing is to ensure that all participants in a particular transaction are on the same page.

A very light touch on due diligence may be suitable in a private placement or a marketed club deal, where the investors have a very clear understanding of the issuer, its strategy and its control group. It may be suitable if the investors in that club deal are able to assess that particular issue and issuer. The risk is when those types of light touch executions are all of a sudden applied in deals that are marketed in the more normal way. It is important to adhere to a comprehensive due diligence standard if it is a real marketed deal. 

At the same time, we have new bank entrants to this market, and they have grown up in the onshore market and have developed different processes and procedures for how they place bonds onshore. There’s going to be an import of certain methods from onshore bond offerings. We have seen that in the terms of the bonds, where, for example, upsizing options have popped up. We have seen a couple of bonds which had a ‘term plus’ approach, where investors had to put at a certain point of time. Those were features that came originally from the onshore market, and these influences will be a fact of life. 

Fung, BFAM Partners: It’s not just on the due diligence side that investors are concerned. Even on the deal execution side there are different standards from international banks to local security houses, on whether everybody gets bonds re-offered at the same price, whether book messages are consistent with standards required by the SFC [Securities and Futures Commission], for example. Obviously some of these rules are up for interpretation, but clearly some very aggressive interpretations are being taken. I think it takes away investors’ confidence, and if you only have those local security houses on a deal, investors will shy away.

Ho, JPM AM: With investors at different maturities in their lifecycles and experiences in this market, one could only self-regulate within the organisation themselves, rather than relying on the association of the asset managers or relying on the club effort of the industry to make this right. Small issues of $200m-$300m can easily be done without the involvement of a certain party. If a certain investor does not agree to the revised terms and conditions of covenants, then they may lose out on receiving the consent fee when the looser revised covenant has been agreed upon.

One has to balance between their own risk management and the hunger level in the street. And of course, the hunger level on the street will affect your performance, because it’s very driven technically by the size of the market. This is something we have to balance on a day-to-day basis. Unlike the US capital markets, where asset managers can make a concerted effort to bend certain adverse offering circular terms, that is hard to implement in the Asian environment at the moment.

GlobalCapital: I want to touch on the topic of ratings. The issuers here have different histories in that regard: Albert, there seems to have been some lagging on how your rating has improved over time, given the firm’s growth. Has that hurt your funding costs?

Yau, CIFI: Absolutely. I think if you look at the general ratings by the three international agencies against the CRE space they are consistently lower compared to our international peers. However, on the other side, the market is assigning differentiation to issuers, even though the notching of the rating is not there.

Our rating has improved over time, but on the other hand the pricing of our paper has actually outperformed the rating, so the market shows differentiation. The other driving factor here is the Chinese investors. More and more Chinese money is playing a bigger role in this market through the AMCs and security houses. So if you look at the spectrum of the pricing to me it actually mirrors the onshore market right now.

GlobalCapital: Douglas, your firm is not rated; have you thought about it?

Sung, Shui On: It doesn’t really seem like there is a big benefit to having the rating for SOL at this stage, because if you look at how our papers are priced, it certainly reflects a relatively high rating already, although not investment grade. I think it’s unlikely we would see a significant cost impact even if we were to get a rating. So in the short term, because the company and our chairman are very well known in the region, being without a rating hasn’t been an issue.

However, as I mentioned, a key direction for Shui On has been to deleverage and to be financially more sustainable. And if we are able to achieve our objectives in the next year or two, then maybe we will consider getting a rating, if we believe we can get up to investment grade — otherwise there’s really no point in doing it.

Teng, Standard Chartered: For CIFI and similarly rated peers, my view is that the rating agencies have lagged the market. If I look at Albert’s case, CIFI has doubled Ebitda in the last couple of years, their funding cost has improved tremendously, coupons have halved. The company’s margins have continued to be very good, but they have only been rewarded with a one notch upgrade during this.

Shui On is unique. Not every unrated company out there will have the ability to access the bond market in the scale that Douglas is able to do. I do think ratings are important, particularly for debut issuers. Generally speaking, only a very recognisable name can pull off issuing unrated bonds. Depending on the size of the issuer’s future funding needs, an issuer may also want to think about how big an investment pool it wants to target, long term. Hong Kong is unique in that there are many issuers with high name recognition, particularly from the real estate sector. Those with established MTN programmes are able to raise small amounts of unrated bonds with no high yield covenants. But there is a size limit to this market. 

Generally speaking, for $300m or more, some of these issuers may struggle without ratings. Ratings may also impact the LTV [loan to value ratios] provided by private banking institutions, which could impact the ultimate pricing level.

Li, Car Inc: I like the agencies and I value them. They need to work hard for cases like ours, they spend a lot of time on just one company, it takes a lot of effort to understand the business. I don’t see the rating agencies looking down on China. Mostly they are bottom-up, looking at specific industries. Also, it is important for Chinese companies to get international ratings, first to help them for dollar funding offshore, but it is also a good training process. That rigour can help strengthen your credit profile. That push to get a rating helps you to get confident and improve your thought process. It helps the company in the long run.

GlobalCapital: Shaw Yann, how do you look at ratings and how do you think about unrated firms? Where do you draw the line?

Ho, JPM AM: I think without ratings formally granted by credit rating agencies we’ll be very stringent to price them to the cycle. I think the agencies are behind the curve because they don’t see the issuers on a one year performance basis. They want to see that you can do the same thing repeatedly for the next three years.

The whole system is quite leveraged. Although these firms sell very well, they also buy very aggressively on the land bank. So that has caused their leverage levels, especially from the debt over Ebitda perspective, to be on the high range of their ratings. So if an issuer is not rated we have a certain scale in mind of what will be the price of a B and what will be the price of a BB. Or if you realise that a B rated is pricing like a BB we would forgo that single B because we have plenty of BBs to play with.

So from the benefit of the doubt point of view, I think it’s only advantageous for the issuer to gain that kind of formality. Otherwise, a certain group of investors could use a more stringent valuation when it comes to pricing. And because the market is pricing at an all-time tight, we can afford to be very selective.

Fung, BFAM Partners: We don’t necessarily rely on the ratings to tell us the credit quality of a company. Some people may argue that they’re always conservative but I don’t think that’s necessarily the case. If anything they’re probably always a bit behind the curve, whether it’s on the up-trend or the down-trend. We’ve seen many cases of bonds being priced at much worse levels than where they are rated.

I have also seen a recent trend where refinancing risk has become part of the rating. They’re taking into account technicals that don’t necessarily paint the correct fundamental credit picture. What I do look at is how ratings might ultimately affect the bond performance and pricing. Fred mentioned the amount of leverage that private banks can get, it’s the same with all leveraged parties. Any time you are financing, whether you’re an AMC or a fund, you’re financing with banks. Banks will likely use a public rating if it’s available, so that would affect the amount of leverage and the rate that you get. 

Another scenario is if you go from being an investment grade to a high yield issuer, you could see a technical exodus from certain investors that can only invest in investment grade and I think we saw that in a large Chinese developer that went from investment grade to BB last year.

GlobalCapital: Gerhard, what’s the state of play on covenants in Asia? How do we compare Asia and Greater China with the developed markets?

Radtke, Davis Polk & Wardwell: The covenant structure for Asia or Greater China has evolved over time. We did a Shui On bond, one of the very first in the HY space here, over 10 years ago, and the covenant package was extremely tight. Everybody was trying to get their arms around the country and, even more so, around the newly developing real estate industry in China. It meant that every individual lever was tightened by a couple of notches.

Since then the market has changed massively. We now have well known, transparent issuers, like Shui On, that have been in the market for over 10 years, and people are familiar with them. On the other hand, the complexity of issuers and their capital structures has also increased, and with it the need for flexibility in covenants. And that means that these days there is no consistent standard any more, there’s really a variety.

It’s a very different thing if you look at a privately held PRC entity doing a debut issue, compared with a very transparent, well known group like Shui On. Then you have other issuers that may be chasing leverage and may be more aggressive. The market will acknowledge that and, while giving them some flexibility, may also make them pay for it to some extent. So you still see elements of tightness, but you also see issuers that get away with lots of flexibility, whether that is to incur additional leverage or to reorganise their structure. For example, some issuers are looking at the ability to relist at least a portion of their business onshore and are trying to build in flexibility for that into their high yield terms. Such structural flexibility requires significant tinkering with the covenants. This would not traditionally have been available to a high yield issuer. 

At the same time, you see diversification of certain industry groups, which has led some issuers to push back on the traditional limitation on changes to an issuer’s permitted lines of business. Judging from the press coverage, removing that clause seems to have triggered a reaction from investors, who are asking whether that’s a good idea or whether issuers need to specifically pay for that. 

It is usually very difficult to put a price tag on any individual covenant change, but that one has got singled out a little bit. Another interesting question is how to assess whether the issuer will really make use of the flexibility they’ve negotiated for, or whether they just want to remove their constraints, to give them flexibility on the margins. That assessment seems to be as important as the removal of any given covenant itself.

GlobalCapital: Issuers, how are you taking advantage of this changing picture in covenants? What kinds of thing are you getting away with now?

Yau, CIFI: At CIFI we try to follow the market trends and not be too aggressive. In the past five years our covenants generally worked pretty well so we didn’t have to come out for consent request.

There’s no dispute among our China peers that the covenants inherited from the US high yield bonds are unnecessarily complicated. Even on the buy-side you have to think what type of protections they are really offering you. And unlike the US market, where most of the high yield corporates are relying on bond financing, on our side I think we have now less than 50% of our offshore financing coming from bonds.

So when we see there’s a general trend of loosening then we also follow. And while we are always told by the banks if we loosen our covenants beyond a certain extent it will affect the buying interest, we also look at unrated real estate issuers in Hong Kong and Singapore and wonder how an unrated issuer can have a looser covenant than a high yield issuer, and even price at a lower yield. We are always quite puzzled by that. But, of course, this process is more driven by the buyside.

Sung, Shui On: I would tend to agree: ultimately the covenants are driven by market practice. It is very hard for any one specific issuer to push for a very different package, compared to what the market norm is. Maybe you can tweak it, depending on what your needs are, but ultimately it’s really a reflection of demand and what investors are willing to accept and the liquidity condition in the market. 

Having said that, we have just finished a consent request exercise a month ago to relax some of the covenants in the older bonds, because the market is very different now, compared to some of our bonds issued in 2013 and 2014. So we did loosen up quite a lot of those older covenants, which gives us more flexibility in cash management.

GlobalCapital: What are the views from the buy-side?

Ho, JPM AM: If we see anything that’s out of line and we can second guess that there are other people who are on the same side as us, then we wouldn’t give the consent. If there’s a debut issuance where the fundamental strength of the covenant is already weak, coupled with a very weak offering circular of consent conditions, then it’s a no-brainer that we reject the deal upfront.

Fung, BFAM Partners: We’re in a cycle where investors are looking for product, so there’s a yield-grabbing mentality. The attitude is ‘how much can I loosen covenants deal-by-deal so that people don’t make a big issue out of it and it does not affect my pricing?’ I think the market is constantly fine-tuning this. But I’m under no illusion that any group of investors really will be able to hold a crusade.

Teng, Standard Chartered: Historically, high yield bond covenant concepts and structures were introduced from the US, and until five or six years ago the Asian high yield bond market was still very much driven by US-based institutional investors. You had to do Reg S, 144A deals for a particular size to get things done. 

Nowadays it is all Reg S deals we’re doing, and depending on the name, we can do anywhere from $500m up to $1bn in size. I’m sure if Albert or Douglas needed it, these sizes are available for them in the Reg S market now at a price. It’s very different from five, 10 years ago.

But I also think there was an inherent Asia premium associated with Asian covenants. When you look at the FCCR [fixed charge coverage ratio] test, it is significantly higher than their peers in the US and Europe. Looking forward, there will be convergence, there is a need for that. It really depends on how long term issuers want to manage their capital markets relationships. If you only need to tap $200m or $300m every few years you probably can get away with a lot of things. But if you have a much more complex business structure, particularly when it’s constantly driven by regulatory uncertainty, these covenants, although it is a heavier burden, allow issuers to maintain some following with the club of international investors. It is a balancing act and, although it’s not always easy to have a perfect equilibrium, I think investors could accept looser terms than what we have now.

GlobalCapital: The final question for the roundtable: what will be the trends going forward for this market?

Teng, Standard Chartered: China will continue to become more involved globally in terms of M&A and outbound activity. This will create new situations, for example, an Asian high yield issuer issuing bonds in euros. Shandong Ruyi has bought the French retailer SMCP, which had existing euro high yield bonds. I wonder if it would be possible for a Chinese holding company to issue a bond to the same bondholders that own their European operating subsidiaries’ bonds? There will also be changes as property developers become more active in other markets — the name recognition and bank following in these local markets could create new opportunities.

Sung, Shui On: Ultimately, the big overhang is about government regulation of the property market. If there is continued and consistent tightening, certainly that’s not going to be good for issuers — for the pricing and for the demand. Chinese real estate is still a heavily regulated industry and that is what most investors are concerned about: whether the market can function freely or is it still going to be very much driven by government policies.

Yau, CIFI: I’m very positive on the development of our sector in the offshore capital markets. That funding market is too big for us to ignore, so even though in the past few years you see fluctuations, in terms of volume this is a very sustainable market. 

Second thing, I’m also very positive on the market efficiency. The market is getting more and more efficient to allow differentiation, so the pricing is a lot better for good developers compared to maybe five years ago. This will continue.

I’m also a strong believer that our sector, even though there have been a lot of improvements already, is still re-rating. We see the bond market re-rated steadily and dramatically compared to five years ago and there’s also re-rating in the stockmarket. This will continue, so I am generally very positive.

Radtke, Davis Polk & Wardwell: I would expect further broadening of the market, both in depth and scope, not just with respect to structures and types of issuers but largely driven by the globalisation of Chinese enterprises — which will ultimately increase the need for US dollar funds.

GlobalCapital: Final words from the investors at the table?

Ho, JPM AM: We appreciate more competition in the bond market if that’s feasible, giving us more choices. The one thing that stops us from participating in a loan deal compared to a bond deal is because of the daily liquidity issue. If loan deals can offer daily liquidity in the future then perhaps the market will be less one-sided than now.

The other thing is we are subordinated to loan tranches already, so our need to tighten up the terms and conditions of the bond structure is understandable. And I believe this kind of demand is not something that we create unnecessarily but it is just to protect the vested interests of our end-investors.

Fung, BFAM Partners: I expect the offshore bond market will continue to see good performance from China high yield particularly, and the real estate sector as well. It’s very well entrenched in people’s minds that this is a well performing sector. Even in the last couple of weeks, where we’ve seen significant underperformance in non-Chinese high yield, there is still a very strong bid for Chinese high yield. I don’t think that technical will change.

I do think the market will be much more sensitive to single name events versus systemic events that we’ve seen in the past, where the whole Chinese real estate sector cheapens by five, 10 points. Instead of that you’re going to see affected names cheapen by 20-30 points on any significant red flag. That’s the kind of trend we’ve seen and will head towards.

Overall, there’s nothing to really worry about in the broad market except for name selection, especially given how well priced things are. Looking forward, I would also like to see the continued liberalisation of the onshore market, such that it blends in a little bit more with the offshore market. If the ability for offshore creditors to actually have real onshore collateral comes about, I think that will open up a channel and significantly increase offshore participation or the desire to participate in these markets. Right now it’s not feasible, but I think over the coming years that’s probably an area that regulators and issuers are looking into as well. 

Euromoney and Standard Chartered will be running a series of webinars on debt capital markets. The next will be ‘India states’ finances and borrowings: The other half of the story’ on July 19. Find out more.