Starting afresh

Corporate bonds are under new management but glitches in the market remain

Starting afresh


With more undeveloped land to its name than any other Chinese real estate company, Country Garden needed cash to realize its ambitious expansion plans. In November, the Hong Kong-listed firm set out to do just that, announcing the sale of up to US$1.5 billion in high-yield bonds.

Times have been tough for Asian bond issuers since the US subprime mortgage crisis, with once bitten-twice shy American investors tightening their purse strings. Guangdong-based Country Garden hoped to win them over by offering returns of 9.25% and 10% on its five- and 10-year bonds.

Industry insiders noted that this was high but it was a price the company was willing to pay: China’s real estate market is on a roll and, with Beijing trying to rein things in by ordering banks not to make property-linked loans, issuing offshore debt was one of few options left open.

“The Chinese real estate companies don’t care about the yield and this is damaging for the market,” was one Hong Kong investment banker’s verdict. “The growth rates are so high they just want to raise as much money as possible.”

As it turned out, the yield wasn’t high enough to make US investors bite and Country Garden was forced to postpone the deal, prompting claims that the party is over for Chinese developers in Hong Kong’s corporate bond market.

The fact that the company felt it could target what would have been a record bond sale by a Chinese firm in less than favorable conditions is testament to how big a party it has been. In 2003, Greater China accounted for just 3% of the Asian high-yield issues, according to investment bank Merrill Lynch. As of mid-September 2007, its share was 44%. The bulk of recent issues have been property-related.

Small beginnings

One thousand kilometers and a world away, Sino-Diamend Gems & Jewellery Investment is also looking to capitalize on the real estate boom. The Hangzhou-based company started out as a retail and wholesale operation but has since worked its fingers into a lot of different pies, most of them manufacturing-related. Property and construction is next on its agenda.

As a Shanghai-listed firm, Sino-Diamend is more or less isolated from overseas capital markets and, with the government clamping down on real estate lending, it seemed as though it might struggle to raise more money.

All this changed in October when Sino-Diamend announced that it wanted to follow in the footsteps of China Yangtze Power and issue corporate bonds.

Yangtze Power was not the first Chinese company to issue debt in the domestic market, but the US$540 million it raised through the sale of 10-year bonds – which started trading on the Shanghai Stock Exchange on October 12 – marked the dawn of what could be a dynamic new age for corporate bonds.

This is because they were the first bonds released under the China Securities Regulatory Commission (CSRC), which earlier this year took over management of bonds issued by listed companies. Corporate bonds previously fell within the remit of China’s central planning agency, the National Development and Reform Commission (NDRC), which restricted bond issues to a handful of state-owned enterprises (SOEs). The agency has, however, retained control of enterprise bonds, which are issued by non-listed firms.

Under the CSRC, much of the bureaucracy has been axed. Gone is the quota system, which limited the number of bond issues per year, as is the requirement that all bonds be tied to specific projects. From now on, any firm can apply to issue bonds and each case will be judged on financial rather than political merits. If approved, the proceeds of sales can be used to repay bank loans or as working capital.

“I think the move to have CSRC regulate for bond and equity instruments is a meaningful one,” said Paulus Mok, head of Citi’s fixed income, currency and commodities team in China. “It will look to meet the needs of the market and identify the best groups of issuers.”

Quick and easy

The fundamental benefits of selling bonds were outlined by Yangtze Power director Zhang Cheng in comments made at the issuing ceremony in Shanghai. “First, it is a fast, market-oriented capitalization method; secondly, locking costs to fixed-rate bonds saves the company about US$8 million a year; and thirdly, it improves the debt structure by shifting away from short-term instruments to medium- and long-term ones.”

Yangtze Power is saving money and minimizing its risk by borrowing from the market rather than from a bank: A 10-year bond represents a far cheaper and more stable source of financing than a bank loan that rolls over year-by-year.

Yet the vast majority of China’s corporate financial needs are still met by the banking sector. Bank deposits accounted for 70.4% of the country’s financial assets in 2006, according to government figures. Bond and equities were on 11.5% and 18.1% respectively.

The proportions started to change in 2007 but mostly due to the revival of the stock market. Jonathan Anderson, chief Asian economist at investment bank UBS, said in a recent research note that equities now make up 45% of total financial assets, which is more or less on a par with other Asian markets.

The same cannot be said for bonds. Debt accounts for close to a third of financial assets in each of South Korea, Philippines and Malaysia. In the US and Japan this proportion rises to nearly half.

Looking at the China figures more closely, of the US$856 billion of debt issued so far this year, only US$10 billion has been in corporate bonds, with a further US$39 billion in valid-for-under-a-year commercial paper products. The remainder is dominated by government and policy and central bank bonds.

This imbalance in the country’s financial portfolio means that companies may struggle with their financing.

“They say that banks lend you an umbrella when the sun is shining and take it back when it starts to rain – companies are under pressure to pay back when the market is not strong,” said Dr Chen Chung-Hsing, head of Xinhua Finance. “With corporate bonds, it is all about preparing for a rainy day.”

Corporate access to capital is also blighted by banking-sector inefficiency. The country’s lenders, dominated by the Big Four state banks, have not evolved in tandem with the economy, which means that money doesn’t go to places where it would deliver the best returns.

Sorry, small guy

Although the private sector is responsible for 52% of China’s GDP, it and foreign enterprises receive just 27% of bank loans, according to a McKinsey Global Institute (MGI) report published in 2006. SOEs account for 35% of loans and state-controlled shareholding and collective enterprises another 38%.

MGI concluded that channeling more funds to private companies, through measures such as an increased reliance on the equity and bond markets could boost GDP by US$259 billion per year.

“Smaller private enterprises are an important part of the economy and there is no channel to give them funding right now,” said Charlie Ye, head of fixed income at UBS Securities. “Under these new CSRC rules, as long as firms are listed and get their balance sheets sorted out, they can all qualify to issue bonds.”

However, Ye stresses that it may be some time before these smaller companies benefit; as the new corporate bond market gathers momentum, it will be the large firms who get to participate first. Starting off with big-name issuers is in part a means of building up demand among investors. Institutional fund managers value the stability of corporate bonds as much as the companies that issue them, especially in times of negative real interest rates and unpredictable equities.

Foreign investors are just as keen to get involved as domestic ones. Chris Ruffle, co-chairman of MC China, the local joint venture of fund management firm Martin Currie, is planning a new US$500 million fund that will buy a variety of products, including corporate bonds.

Structural faults

The challenge for China’s still-emerging bond market is that the measures taken by the CSRC only go halfway. There are still numerous kinks in the system, often borne of different regulators wanting to minimize the risk exposure in their respective areas of the market.

First among these problems is the issue of bank guarantees. A few months ago, both the NDRC and the CSRC abolished the rule that all corporate bond issues must be backed by a bank. The China Banking Regulatory Commission (CBRC) – conscious that guaranteeing a bond ultimately leaves the financial burden on the shoulders of a banking sector trying to shake off a poor reputation for risk management – moved quickly.

In late October it ordered all domestic lenders to stop issuing guarantees for enterprise bonds. For listed firms, a guarantee can only be given if the bonds have a credit rating of at least AA. This is seen as the first twist of the screw as the CBRC looks to ban guarantees across the board.

The guarantee provision was originally introduced to protect investors in the event of default: Rather than rely on a creaky legal system to extract money from companies that had got in over their heads, investors could simply go to state banks operating on the government’s tab.

Ending this practice throws the risk factor back into the investors’ domain and the China Insurance Regulatory Commission (CIRC), which is responsible for the country’s major institutional investors, is not comfortable with it.

“The CIRC has two regulations on bond purchases: one says the bond must be rated AA or above; the other says it must be guaranteed,” said UBS’s Ye.

According to Ivan Chung, a Beijing-based senior analyst at credit ratings agency Moody’s, many smaller companies have relied on bank guarantees to boost their credit ratings to a level at which the institutions would be interested. Now the banks are being forced to tighten up, these companies could be left in the wilderness. No one wants to move from their position of safety to allow the money to flow.

“Right now it’s a dilemma,” said Joseph Hu, China country head at credit ratings agency Standard & Poor’s (S&P). “The banks are being told not to guarantee corporate bonds, and investors won’t buy them without a guarantee. It looks like we are coming to a standstill.”

Nevertheless, Hu and other industry experts agree that bank guarantees are bad for the market and they will be happy to see the back of them.

“The authorities recognize that allowing banks to guarantee bonds won’t result in a robust market,” said Charlene Chu, director of the Fitch Ratings financial institutions team in Beijing. “This is because the pricing relates to the risk of the bank rather than the risk of the issuer.”

Creating confidence

The solution to this problem is fostering more confidence in the corporate bond market so that investors are willing to take the plunge without a banking sector safety net. A strong government bond market is a key factor, as the yield curve for sovereign debt is used to price other bonds in the market.

Then there is the need for a legal infrastructure that makes investors feel comfortable when buying debt. China’s new bankruptcy law came into effect earlier this year and, while on paper it offers clear procedures and better protection for creditors, it has yet to be really tested.

But the onus is really on the domestic credit ratings agencies and the institutional investors. The agencies must provide independent and reliable assessments of bond issues, and the investors must be able to make purchasing decisions based on this information.

“It’s important for the market to develop confidence in credit ratings – without them, bonds cannot develop healthily and quickly,” said S&P’s Hu.

Giving greater autonomy to the likes of insurers would also lead to a more diversified and dynamic market. Working in conditions that are market- rather than regulator-driven, investors could build portfolios that encompass a variety of risks and maximize potential returns.

Industry participants have called for a broadening of the investment channels, but they accept that high-level personnel changes within the regulatory bodies, supposedly decided at October’s Communist Party Congress, may slow the process. Fundamental policy changes are unlikely before the National People’s Congress in March, when any new appointments would be made public.

At the top of their wish list is an end to the restrictions on insurance companies but they are also keen to see commercial banks play a greater role. At present, these lenders can only really buy policy bank and government bonds.

“Commercial banks globally are a major participant in the market but at the moment their involvement in China is limited,” said Citi’s Mok.

Moving forward

Finding common ground among the country’s fragmented financial regulators – so that they can move forward and fix the structural problems in the corporate bond market – will be a slow process.

Given the relative immaturity of China’s capital markets and the people who work in them, some industry experts see incremental progress as a blessing in disguise: That way, for example, the CSRC can ensure domestic credit-ratings agencies are reliable before asking them to carry out analysis on which billions in institutional money might rest.

For now, the equities market appears to be working in favor of the incrementalists. With the Shanghai Composite Index up nearly threefold so far this year, investors are chasing 5% monthly gains on stocks rather than 5% annual gains on bonds. But the way in which investors have flocked to China’s stock market – and demand inflating prices beyond reasonable levels – is indicative of the kind of volatility that bonds are there to counterbalance. In the event of an equities slump or a credit crisis, corporations with too much exposure in these areas would struggle to raise money or pay off existing debts; if some of their income or debt were tied to long-term bonds, they would not.

“China’s capital markets are at an early stage of development compared to those in the West, which leaves the banking sector exposed to a much larger portion of the country’s financial and credit risks,” said John Pratt, head of Asia debt capital markets at Merrill Lynch. “As such, domestic banks – and by implication the economy as a whole –  are limited in their ability to mitigate this risk by selling it on to other financial intermediaries.”