To foreign bondholders of Fosun International, concerns seem to be growing around the business prospects of the Chinese industrial conglomerate. To its onshore Chinese bondholders, however, the business outlook looks rosy.
The situation is the same at China Shanshui Cement Group. The yuan notes it issued in October 2010 are rated AA by a Chinese agency, yield around 5.29 percent, with a spread of 242 basis points over three-year Chinese government bonds.
But the Shandong province cement maker pays double the coupon on a $400 million tranche of five-year senior unsecured notes issued in May 2011. Those bonds, which Fitch rates as BB-, now yield 9.71, a spread of 885 basis points over five-year US Treasuries. Fosun and China Shanshui Cement are just two examples of Chinese companies whose onshore yuan bonds are considered investment grade by domestic investors but treated as risky, high-yield plays by offshore investors. The striking gap in credit spreads has emerged since a flood of new Chinese corporate paper hit the offshore market beginning in 2010.
Onshore market participants say the difference in yields highlights the lack of sophisticated risk assessment by both investors and ratings agencies within China, where investors widely assume that underwriters or the government would step in to rescue bondholders if a company appeared on the verge of default.
"We don't really have a credit-risk culture," said a Chinese bond trader at a foreign bank in Shanghai, referring to the domestic market.
Foreign investors, for their part, worry about their ability to claim onshore assets in the event a mainland borrower fails to repay. In the equity market, mainland companies with shares listed in both Shanghai and Hong Kong sometimes trade at different prices in the two markets.
But only at the height of the mainland equity bull market in 2007 did the premium for mainland shares approach the levels now seen in the mainland bond market. And Hong Kong shares actually traded above Shanghai counterparts at the depths of the mainland market's slump in 2011. Before 2010, the supply of offshore bonds from mainland companies was negligible, as Chinese companies were able to access all the credit they needed from mainland banks.
After that, issuance exploded, as China's central bank tightened monetary policy aggressively in an effort to control the inflationary aftermath of the lending binge associated with the country's 2008-2009 economic stimulus program.
New dollar-bond issuance by mainland firms totalled $39 billion in 2010 and 2011, according to Thomson Reuters data. More than half that came from property developers, who faced particular difficulty raising funds onshore due to efforts by authorities to tamp down soaring housing prices. But issuance slowed in the second half of 2011, as concerns grew about corporate governance at Chinese firms and a possible hard landing in the Chinese economy reduced investor appetite for fresh paper. Only three Chinese companies have tapped the offshore market so far in 2012, in deals totalling $1.3 billion.
Yields on offshore bonds, which already featured higher coupons than their onshore counterparts at the time of issuance, have risen further. The gap in spreads is able to persist because unlike other large emerging Asian bond markets such as Indonesia or India, China's onshore bond market is effectively closed to foreign investors, while Chinese investors are mostly prevented by the country's capital controls from investing abroad.
The biggest factor worrying offshore investors about bonds from Chinese issuers is the ability to recover assets in the event of a default. Since the country's bond market is so young, historical data on recovery rates is lacking, and China's bankruptcy laws remain, at best, untested.
Such concerns contribute to the lower ratings by international agencies. Fitch ratings classifies China among "jurisdictions not supportive of creditors rights, and/or where significant volatility in the application of law and enforceability of any claim materially limits the practical chances of recovery," according to a Fitch presentation at a recent Asian bond forum in Shanghai.
Fitch warned in a separate note in March that bond covenants for "dim sum" bonds - offshore yuan (CNH) bonds issued in Hong Kong - offer investors even weaker protections than dollar bonds from the same issuers.
"The higher yields being offered [for offshore bonds] are to compensate investors for the risks of being an offshore structure, which means less claim on the underlying asset," said Henry Wong, a fund manager at BEA Union in Hong Kong, the money management arm of Bank of East Asia. "This is a risk that investors have to understand, that higher returns on your investments will mean you have to take on a higher risk."
A significant issue for the debt market is the holding structures used by Chinese companies to issue offshore bonds. The bonds are often issued via offshore subsidiaries in Hong Kong or tax havens like the Cayman Islands.
The offshore issuing entity often has few assets beyond shares of company stock, which would be worthless in the event of default.
In addition, funds raised offshore are often injected into the onshore operating companies as equity. Thus, from the perspective of Chinese law, coupon payments on offshore bonds are classified as dividends. But Chinese foreign exchange requirements make it difficult to pay dividends until all onshore liabilities have been met.
The effect of these factors creates what Fitch calls "structural subordination." As a result, Fitch's ratings treat all onshore debt by Chinese issuers as senior to offshore debt, regardless of the content of the covenants of an offshore issuance.
The unlisted parent of China State Construction Engineering issued 10 million yuan in 10-year medium-term notes in late 2010 at a coupon of 4.080. The notes, which China Chengxin International Rating Co, a domestic agency, rate as AAA, now yield 5.22 percent, a spread of 169 bps over Chinese government bonds.
When a Cayman Islands subsidiary issued $1 billion in 10-year bonds in the offshore market just one month later, the market demanded a 5.50 percent coupon. The bonds, which S&P rates BBB, now trade slightly above par and yield 5.49 percent, but this rate still represents a spread of 349 basis points over US treasuries.
The role of the ratings agencies is also key to understanding China's divergent bond markets. Chinese ratings agencies offer investment-grade ratings more generously than their foreign counterparts.
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