Defaults, breaches & covenants in offshore RMB bonds

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Special RepoRt: Defaults, breaches and covenants in offshore RMB bonds

la bond default in the dim sum market is inevitable as the mark

grows as the majority of issues are from high yield or non-rated

names.

lGlobal Bio-Chem became the first known issuer to breach the

covenants on an offshore renminbi bond.

lMany offshore renminbi bonds sold when the market was

starting did not have covenants as investors were more

focused on currency appreciation than credit risk.

linvestors are expected to start differentiating between different

types of bond covenants as the market matures and they seek

more protection. the main two types are incurrence covenants

and maintenance covenants.

linvestor demand will also increase the inclusion of covenants

in offshore renminbi bond issuance.

lthe guarantees on offshore renminbi bonds designed to protect

investors may not be enforceable in chinese courts and as a

result more pre-sale analysis should be carried out on credits.

lDebt capital markets bankers have an important role to play

in educating investors and issuers about the pros and cons of

covenants and guarantees.

SuMMaRy

November 2012

2 | www.asiamoney.com/RMB2 | www.asiamoney.com/RMB

DEALING WITH A DEFAULT IN THE DIM SUM MARKET

as the offshore renminbi bond market continues to mature the likelihood grows that eventually one or more of these borrowers will default on their debt. that poses an issue, given the unprecedented nature of this fast-evolving market.

Hong Kong-based lawyers that have advised on the contracts for dim sum bonds say an offshore renminbi bond default would look very much like a eurobond default, or the default of a bond denominated in a currency other than the uS dollar - at least at the beginning.

“a dim sum bond behaves like any international bond in the sense that, if there is a default, then under the terms of the note there are specific provisions dealing with what to do,” said peter Kwon, a partner at ashurst in Hong Kong. His company has advised on several recent dim sum deals, the identities of which Kwon declined to reveal.

When a CNH bond issuer first skips an interest payment, bondholders may grant the borrower a grace period of a few days to get its finances in order. If there’s still no payment, it’s the bondholders’ contractual right to demand the full principal immediately, regardless of the bond’s maturity date.

as most cNH bonds have been issued from Hong Kong, the first port of call would be the Hong Kong High court, where bondholders could sue the dim sum issuer for their unpaid interest and principal. presuming the court is in agreement, a judge would then give investors official claim to their capital. Investors would

have to bring this claim to the court of the issuer’s home jurisdiction.

as the nature of cNH bonds is global, that will mean taking their claims to judges in the Americas, Europe, Middle East or Asia Pacific, who will then command that issuers pay their commitments.

this is where cNH bond and eurobond contracts differ.

“With most bond issuers, they have some form of collateral – whether that’s factories, equipment or other assets – that can be sold and generate liquidity in the currency that they have to repay in,” explained one Hong Kong-based lawyer at a firm that has advised on dim sum bonds including those issued by agricultural Development Bank of china, Raiffeisen Bank and emirates NBD. “in cNH, oftentimes these issuers don’t have any assets to pledge for or any accounts in renminbi, so these bonds are essentially unsecured.”

Because China’s capital accounts remain strict, and gaining access to more renminbi is tricky, contracts frequently contain a clause that gives issuers the option of using a separate currency as a proxy for renminbi repayment – namely uS dollars.

“chinese renminbi is not like uS dollars in terms of its accessibility, so there are clauses in the documents that I’ve written where—in certain circumstances where it is impossible or difficult to obtain renminbi—there’s a formula to use other currencies for repayment, like uS dollars,” said Ashurst’s Kwon.

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A question of experience

there are other incongruities that may arise. according to one Hong Kong-based lawyer, if an american issuer were to default, the american court system is practiced and efficient at producing repayments, given that defaults are regular occurrences in the market.

But in a country like china the courts are untested because the nation hasn’t ever seen default in its own bond market.

“if a Hong Kong or english court says that a company owes you money, that’s all fine and you can put that claim in your pocket. But if you take a plane to Beijing and tell the court to give you the keys to the house, you won’t necessarily see those kinds of results,” he said. “Getting default claims enforced in the People’s Republic of China (PRC) is less straightforward.”

While another lawyer concedes that the Chinese court will honour investors’ claims on defaulted bonds, the process won’t be speedy.

“there may be challenges in going through the pRc system,” the lawyer said. “of course the court system in Hong Kong or london or New york is very advanced and they have a history of case law and are familiar with these products, but the relative unfamiliarity in china around international deals will protract the process of getting repayments. That’s the risk in dealing with china.”

It’s a risk that dim sum investors will most likely become more exposed to. in 2012, 49.7% of dim sum bonds were issued by chinese borrowers. Furthermore in May, the National Development and Reform Commission (NDRC) eased regulations for chinese companies to issue cNH-denominated bonds, giving corporates the opportunity to raise offshore debt for the first time.

Offshore RMB DCM Ranking by Deal Nationality

Data as of october 16, 2012Source: Dealogic

China

Hong Kong

South Korea

Germany

United States

France

United Kingdom

Japan

India

United Arab Emirates

Netherlands

Taiwan

Australia

Mexico

Malaysia

Sweden

Austria

O�shore RMB DCM Ranking by Deal Nationality

2010

2012 YTD

3 years

2 years

5 years

7 years

10 years

1 year

4 years

3 years

2 years

5 years

15 years

9 years

1 year

20 years

14 years

7 years

10 years

O�shore RMB DCM Ranking by Years to Maturity, 2010

2010

3 years

2 years

5 years

10 years

2011

2012 YTD

2011

China

Hong Kong

France

Germany

United States

Singapore

Macao

United Kingdom

Japan

Taiwan

South Korea

India

Malaysia

New Zealand

Sweden

China

Hong Kong

Philipines

United States

Russian Federation

Switzerland

Australia

49.7%

10.0%

7.9%

5.0%

3.9%

3.9%

3.3%

2.7%

2.1%

1.7%

1.6%

1.5%

1.5%

1.4%

1.4%

1.2%

1.1%

79.7%

9.6%

3.4%

3.4%

2.8%

0.6%

0.6%

2012 YTD

2010

China

Hong Kong

South Korea

Germany

United States

France

United Kingdom

Japan

India


Netherlands

Taiwan

Australia

Mexico

Malaysia

Sweden

Austria

53.5%

18.0%

4.6%

4.4%

4.2%

3.3%

2.6%

2.5%

2.0%

1.7%

1.3%

0.7%

0.6%

30.3%

0.2%

2011

China

Hong Kong

France

Germany

United States

Singapore

Macao

United Kingdom

Japan

Taiwan

South Korea

India

Malaysia

New Zealand

Sweden

China

Hong Kong

Philipines

United States

Russian Federation

Switzerland

Australia

China

Hong Kong

South Korea

Germany

United States

France

United Kingdom

Japan

India


Netherlands

Taiwan

Australia

Mexico

Malaysia

Sweden

Austria


2010

2012 YTD

3 years

2 years

5 years

7 years

10 years

1 year

4 years

3 years

2 years

5 years

15 years

9 years

1 year

20 years

14 years

7 years

10 years


2010

3 years

2 years

5 years

10 years

2011

2012 YTD

2011

China

Hong Kong

France

Germany

United States

Singapore

Macao

United Kingdom

Japan

Taiwan

South Korea

India

Malaysia

New Zealand

Sweden

China

Hong Kong

Philipines

United States

Russian Federation

Switzerland

Australia

49.7%

10.0%

7.9%

5.0%

3.9%

3.9%

3.3%

2.7%

2.1%

1.7%

1.6%

1.5%

1.5%

1.4%

1.4%

1.2%

1.1%

79.7%

9.6%

3.4%

3.4%

2.8%

0.6%

0.6%

2012 YTD

2010

China

Hong Kong

South Korea

Germany

United States

France

United Kingdom

Japan

India


Netherlands

Taiwan

Australia

Mexico

Malaysia

Sweden

Austria

53.5%

18.0%

4.6%

4.4%

4.2%

3.3%

2.6%

2.5%

2.0%

1.7%

1.3%

0.7%

0.6%

30.3%

0.2%

2011

China

Hong Kong

France

Germany

United States

Singapore

Macao

United Kingdom

Japan

Taiwan

South Korea

India

Malaysia

New Zealand

Sweden

China

Hong Kong

Philipines

United States

Russian Federation

Switzerland

Australia

China

Hong Kong

South Korea

Germany

United States

France

United Kingdom

Japan

India


Netherlands

Taiwan

Australia

Mexico

Malaysia

Sweden

Austria


2010

2012 YTD

3 years

2 years

5 years

7 years

10 years

1 year

4 years

3 years

2 years

5 years

15 years

9 years

1 year

20 years

14 years

7 years

10 years


2010

3 years

2 years

5 years

10 years

2011

2012 YTD

2011

China

Hong Kong

France

Germany

United States

Singapore

Macao

United Kingdom

Japan

Taiwan

South Korea

India

Malaysia

New Zealand

Sweden

China

Hong Kong

Philipines

United States

Russian Federation

Switzerland

Australia

49.7%

10.0%

7.9%

5.0%

3.9%

3.9%

3.3%

2.7%

2.1%

1.7%

1.6%

1.5%

1.5%

1.4%

1.4%

1.2%

1.1%

79.7%

9.6%

3.4%

3.4%

2.8%

0.6%

0.6%

2012 YTD

2010

China

Hong Kong

South Korea

Germany

United States

France

United Kingdom

Japan

India


Netherlands

Taiwan

Australia

Mexico

Malaysia

Sweden

Austria

53.5%

18.0%

4.6%

4.4%

4.2%

3.3%

2.6%

2.5%

2.0%

1.7%

1.3%

0.7%

0.6%

30.3%

0.2%

2011

China

Hong Kong

France

Germany

United States

Singapore

Macao

United Kingdom

Japan

Taiwan

South Korea

India

Malaysia

New Zealand

Sweden

China

Hong Kong

Philipines

United States

Russian Federation

Switzerland

Australia


this year has also seen more issuer diversification. On March 14, Ford Motor became the first high yield issuer into the dim sum market, selling a four-year, Rmb1 billion (US$160.5 million) note priced at 4.875%. While its yield was touted as an uncharacteristically low coupon for sub-investment-grade debt—the company is rated ‘Ba1’ by Moody’s, ‘B-’ by Standard & Poor’s and ‘BB’ by Fitch—Ford was still heralded for opening up the cNH market for high yield issues.

“With the entrance of issuers with a wider range of credit ratings, the documentation will also need to continue to evolve, which is currently going in the right direction,” says Ashurst’s Kwon.

according to another lawyer with experience working on dim sum bond deals, chinese companies will also likely have clauses in their contracts that allow them to pay back their principal in dollars in the case that they default.

“There’s always going to be that remittance issue regarding China’s foreign exchange controls,” he explains. “chinese market players will have access to dollars for trading and they can borrow in dollars. even for these chinese names it would be easier to repay their global investors in dollars rather than trying to convert more renminbi if they default.”

Offshore RMB DCM Volume by Effective Rating (Launch)

AAA

AA+

AA

AA-

A+

A

A-

BBB+

BBB

BBB-

BB+

BB

BB-

Not rated


O�shore RMB DCM Volume by E�ective Rating (Launch)

2012 YTD

3 years

2 years

5 years

7 years

10 years

1 year

4 years

3 years

2 years

5 years

15 years

9 years

1 year

20 years

14 years

7 years

10 years


2010

3 years

2 years

5 years

10 years

2011

2012 YTD

2011

Total deal value 2011 $ (m): 5,362


Total deal value 2012 YTD $ (m): 11,072

2012 YTD

2011

2010

3.2%

1.2%

5.2%

8.1%

10.1%

13.4%

1.8%

1.4%

4.6%

0.9%

2.5%

0%

1.7%

45.9%

AAA

AA+

AA

AA-

A+

A

A-

BBB+

BBB

BBB-

BB+

BB

BB-

Not rated

2.3%

0%

0.2%

3.8%

2.0%

12.7%

5.2%

3.3%

0.4%

0.7%

0%

1.1%

5.6%

62.5%

AAA

AA+

AA

AA-

A+

A

A-

BBB+

BBB

BBB-

BB+

BB

BB-

Not rated3.4%

0%

0%

0.6%

14.0%

0.5%

0%

2.8%

0%

0%

0%

0%

0%

78.7%

AAA

AA+

AA

AA-

A+

A

A-

BBB+

BBB

BBB-

BB+

BB

BB-

Not rated




AAA

AA+

AA

AA-

A+

A

A-

BBB+

BBB

BBB-

BB+

BB

BB-

Not rated



2012 YTD

3 years

2 years

5 years

7 years

10 years

1 year

4 years

3 years

2 years

5 years

15 years

9 years

1 year

20 years

14 years

7 years

10 years


2010

3 years

2 years

5 years

10 years

2011

2012 YTD

2011




2012 YTD

2011

2010

3.2%

1.2%

5.2%

8.1%

10.1%

13.4%

1.8%

1.4%

4.6%

0.9%

2.5%

0%

1.7%

45.9%

AAA

AA+

AA

AA-

A+

A

A-

BBB+

BBB

BBB-

BB+

BB

BB-

Not rated

2.3%

0%

0.2%

3.8%

2.0%

12.7%

5.2%

3.3%

0.4%

0.7%

0%

1.1%

5.6%

62.5%

AAA

AA+

AA

AA-

A+

A

A-

BBB+

BBB

BBB-

BB+

BB

BB-

Not rated3.4%

0%

0%

0.6%

14.0%

0.5%

0%

2.8%

0%

0%

0%

0%

0%

78.7%

AAA

AA+

AA

AA-

A+

A

A-

BBB+

BBB

BBB-

BB+

BB

BB-

Not rated




AAA

AA+

AA

AA-

A+

A

A-

BBB+

BBB

BBB-

BB+

BB

BB-

Not rated



2012 YTD

3 years

2 years

5 years

7 years

10 years

1 year

4 years

3 years

2 years

5 years

15 years

9 years

1 year

20 years

14 years

7 years

10 years


2010

3 years

2 years

5 years

10 years

2011

2012 YTD

2011




2012 YTD

2011

2010

3.2%

1.2%

5.2%

8.1%

10.1%

13.4%

1.8%

1.4%

4.6%

0.9%

2.5%

0%

1.7%

45.9%

AAA

AA+

AA

AA-

A+

A

A-

BBB+

BBB

BBB-

BB+

BB

BB-

Not rated

2.3%

0%

0.2%

3.8%

2.0%

12.7%

5.2%

3.3%

0.4%

0.7%

0%

1.1%

5.6%

62.5%

AAA

AA+

AA

AA-

A+

A

A-

BBB+

BBB

BBB-

BB+

BB

BB-

Not rated3.4%

0%

0%

0.6%

14.0%

0.5%

0%

2.8%

0%

0%

0%

0%

0%

78.7%

AAA

AA+

AA

AA-

A+

A

A-

BBB+

BBB

BBB-

BB+

BB

BB-

Not rated






Offshore RMB DCM Volume by Effective Rating (Launch)


investors are expected to start differentiating between different types of covenants as the market matures with incurrence covenants taking over from maintenance covenants.

RMB covenant breach

on august 31, Global Bio-chem technology Group announced that it had breached a covenant on its dim sum bond (see box: The first dim sum covenant breach).

Global Bio-Chem’s experience offers a valuable lesson on the importance of covenants for dim sum bonds, and dealers insist that investors and issuers alike should become more aware of the types of covenants they use in their high yield deals as the differences between them could have drastic results (see box: Maintenance vs. incurrence).

OFFSHORE RENMINBI COVENANTS

The first dim sum covenant breach

On August 31, Global Bio-Chem announced that it had breached covenants on its, Rmb450 million (US$70.8

million) three-year 7% dim sum bond sold May 6, 2011 via HSBC due to losses generated in the first half of 2012.

According to the bond’s offering circular, Global Bio-Chem has five financial covenants attached to the bond

whereby it must adhere to specific requirement regarding its maximum leverage ratio, minimum current ratio,

a fixed-charge coverage ratio, its dividends and its consolidated tangible net worth, the latter of which cannot

drop below HKD8 billion (US$1.03 billion).

The company did not specify which of these covenants was in danger of being breached, though one fixed

income source suggests that “in theory there are a few that they could have triggered”.

“It’s possible that with its weak first half of the year that its cash has come down, or it has marked down its

inventory, or is has taken on bank loans that increased short term leverage – a combination of factors could

have put the company in this position,” he added.

on November 8, the borrower said it was offering to buy back its outstanding bonds at par. it will also pay a

HKD0.10 consent fee to investors. at the time of the announcement, the bonds were trading in the secondary

market at around 88.

If 75% of investors agree to this tender, the terms of the contract for existing investors who opted out of the

buyback also change. Global Bio-chem would reserve the right to redeem its remaining bonds at any time

and would only be required to pay 95.

Debt capital market (DCM) sources indicate that Global Bio-Chem’s decision to buy back bonds was the result

of discussions with key investors. They agree that the move is a valid way for the company to prove its financial

strength and will help it preserve its reputation in the overseas capital markets.


“you have maintenance covenants on a bond and incurrence covenants on bonds, and an issuer may think that incurrence covenants gives them a lot more flexibility. But that short-term security can mean big problems in the long term,” said one head of debt capital markets (DCM) at a leading dim sum bookrunner bank. “this can be the difference between merely having a technical default – which does happens to good companies – to a real, systemic default.”

according to augusto King, head of asia DcM at RBS, “the large portion” of offshore renminbi bonds for unrated and high yield issuers have maintenance covenants rather than incurrence covenants, if they have any at all.

this is due to a few factors, with tenors being one of them. Shorter-dated debt often uses maintenance covenants because the contracts for these bonds are less complex and are in line with investors’ current view of the company.

“With short-dated bonds, at three years or less, investors are buying the bonds based on the credit profile of the company today. Typically a company is able to maintain these metrics throughout the genesis of the bond, and this suits maintenance covenants,” said one DcM banker. “and an incurrence covenant package can be 70 pages long. if a company is only raising a small amount for just three years, and considering the cost of lawyers for the transactions to explain all of the features, it isn’t necessarily worthwhile for short-dated issuer to try to understand what it’s about. Maintenance covenants are less complex.”

He adds that, as most high yield dim sum bonds in the market are less than three years, this accounts for the prevalence of maintenance bonds.

3 years

2 years

5 years

7 years

10 years

1 year

4 years

O�shore RMB DCM Ranking by Years to Maturity

2010

3 years

2 years

5 years

10 years

2011

3 years

2 years

5 years

15 years

9 years

1 year

20 years

14 years

7 years

10 years

2012 YTD

3 years

2 years

5 years

15 years

9 years

1 year

20 years

14 years

7 years

10 years

45.7%

35%

9.0%

3.6%

1.7%

1.6%

1.4%

1.4%

0.3%

0.2%

2012 YTD

3 years

2 years

5 years

7 years

10 years

1 year

4 years

2011

60.7%

20.0%

15.5%

1.9%

1.7%

0.1%

0.1%

3 years

2 years

5 years

10 years

2010

50.6%

32.6%

10.6%

6.2%

3 years

2 years

5 years

7 years

10 years

1 year

4 years


2010

3 years

2 years

5 years

10 years

2011

3 years

2 years

5 years

15 years

9 years

1 year

20 years

14 years

7 years

10 years

2012 YTD

3 years

2 years

5 years

15 years

9 years

1 year

20 years

14 years

7 years

10 years

45.7%

35%

9.0%

3.6%

1.7%

1.6%

1.4%

1.4%

0.3%

0.2%

2012 YTD

3 years

2 years

5 years

7 years

10 years

1 year

4 years

2011

60.7%

20.0%

15.5%

1.9%

1.7%

0.1%

0.1%

3 years

2 years

5 years

10 years

2010

50.6%

32.6%

10.6%

6.2%

3 years

2 years

5 years

7 years

10 years

1 year

4 years


2010

3 years

2 years

5 years

10 years

2011

3 years

2 years

5 years

15 years

9 years

1 year

20 years

14 years

7 years

10 years

2012 YTD

3 years

2 years

5 years

15 years

9 years

1 year

20 years

14 years

7 years

10 years

45.7%

35%

9.0%

3.6%

1.7%

1.6%

1.4%

1.4%

0.3%

0.2%

2012 YTD

3 years

2 years

5 years

7 years

10 years

1 year

4 years

2011

60.7%

20.0%

15.5%

1.9%

1.7%

0.1%

0.1%

3 years

2 years

5 years

10 years

2010

50.6%

32.6%

10.6%

6.2%

Offshore RMB DCM Ranking by Years to Maturity



Offshore RMB DCM Ranking by Years to Maturity


Influence of syndicated loans

But maintenance covenants are additionally in favour because of the way the market has developed. at the start of this market many dim sum bonds didn’t have covenants as investors were keen to participate in the offshore market under the belief that the renminbi would appreciate against the dollar. But the market has since matured, investors have become more discerning about where they put their money and the creditworthiness of companies.

investors then began demanding more covenants on their bond deals, and asian bookrunners, which tend to be more familiar with loan structures, began introducing maintenance covenants, says King.

“Maintenance covenants are extremely common in syndicated loans because lenders prefer that level of control over a company. So that’s what bankers have typically dealt with and what issuers are also familiar with,” said King. “So now, borrowers that don’t fully appreciate or understand the typical high yield bond incurrence package would continue to implement what they know, which is maintenance covenants.”

Investor options in the case of a covenant breach

yet these agreements could turn problematic for issuers. Maintenance covenants give a company greater flexibility to incur debt as needed to grow their company, and only become problematic when its overall earnings and capitalisation levels deteriorate.

at that point, investors can demand the accelerated repayment of their bond

principal. this is a lengthy court process and rarely comes to fruition, but if the company is not granted a waiver to defer then the bond issuer is obligated to pay investors back.

the bond issuer can appeal for a waiver to delay this payment – yet this is where the process becomes far more difficult for a bond issuer than a loan borrower.

With a loan, the company can appeal to its bank lenders – usually just a handful – to delay repayment, justifiable by its earning potential and its assets. often, these companies have a strong enough relationship with these banks that they accommodate the borrower’s request.

But with a bond, a company has potentially hundreds of investors, and tracking down each of them to make an appeal to delay repayment is nearly impossible. in this case, investors are more likely to demand accelerated payment – and depending on the bond issuer’s financial position, the move could force the company into full default.

“That’s where the real problem comes in: a company can go from a technical default into bankruptcy because it can’t negotiate with all its investors. It’s very difficult to do it,” said the DcM head. “and if you look at the dim sum market, there was a rash of high yield deals done last year with maintenance covenants – it’s actually quite surprising that banks advised them into this covenant because it could mean long-term strife for both the company and investors.”

in this instance, if the company had instead agreed to incurrence covenants, much of this process could be avoided because limitations would have stopped the company from taking on additional debt rather than cornering it into default.


With incurrence covenants, even if a company’s profitability or net worth deteriorates, it won’t be held liable as long as can pay its interest and principal on its bond.

“In the case of incurrence, if you don’t meet your debt test then you simply can’t borrow further. But in maintenance

covenants, if you can’t meet your requirements then you’re in breach,” said King. “this would require a remedy otherwise it would cause a chain reaction into its other debt through cross-default provisions.” (see box: Maintenance vs. incurrence)

Lessons to be learned

although Global Bio-chem has not yet caused investors to lose money, the case should act as a lesson to the wider market.

“lead managers on deals need to play an active role in educating their clients about the appropriate covenants to use in their offerings – we need to tell clients that, if you want maintenance, this is what you get,” said King.

Market insiders say that education about the definition of these covenants is an essential step in this phase of the dim sum market’s development as many high yield issuers in particular are finding the covenants are essential to attract investors. and investors as well need to know the pros and cons of investing in bonds with each type of covenant.

“In the high yield dim sum market, we’ve predominantly seen maintenance covenants, but when it comes to high yield in someplace like the US, it’s nearly 100% incurrence covenants,” said one Hong Kong-based lawyer. “I’m always amazed coming from the US that there’s so much knowledge about the differences of these covenants, and dim sum isn’t at that stage yet. And it’s difficult to predict when that will change; I haven’t seen more dim sum issues that include incurrence.”

Maintenance vs. incurrence

Maintenance covenants – used for high yield

bonds, such as those attached to Global Bio-

Chem’s dim sum bond - essentially dictate that

bond issuers and loan borrowers adhere to

specific terms related to the financial health of the

company. these terms need to be maintained

throughout the life of the bond or loan, and

are tested at regular intervals. as long as the

company is able to prove its financial health, it is

in compliance of its covenants.

With maintenance covenants, companies are

able to take on additional debt to grow their

business, as long as specific capital ratios related

to factors such as net worth and earnings before

interest, taxes, depreciation and amortisation

(Ebitda) don’t fall below a predetermined level.

Meanwhile, incurrence covenants limit a

company when it seeks to accrue additional

debt. a company will typically be allowed to

refinance or take on loans up to a predetermined

amount but covenants thwart it from over-

leveraging.

the parameters will vary from issuer to issuer,

but generally, if investors are wary about a

company’s performance, the company will

have stricter borrowing limitations. and if investors

are confident, these companies will have more

flexibility to borrow.


“institutional investors tend to understand the incurrence test better, but banks that participate in these trades understand the maintenance clause better because they’re used to using them in syndicated loans. And if you’re a bank or an institution that’s not investment grade, they might choose the maintenance clause because it gives them initial flexibility but will give them trouble down the line,” added the DcM head. “It’s a balance that needs to be struck.”

But given the lessons of Global Bio-chem, dealers predict that greater understanding of incurrence covenants will lead to more of its use in high yield dim sum bonds – though the speed of its update will depend on what companies’ over-arching goals are.

“One covenant isn’t better than another per se, but we have seen a lot more maintenance covenants because it’s what certain issuers seem to understand. With time and education, more people will also understand incurrence covenants and that will mean more issuers will use it,” concluded King. “it will really depend on what sort of flexibility issuers want and their positioning in their long- and short-term operations. But education to help issuers to decide all this is the most important part.”


The need for dim sum clarity

While dim sum participants are reassured that a

system is in place in the event of a covenant breach,

the reality is that most cNH bond investors lack this

level of protection on their investments – especially on

their high yield bonds.

“The risk here is that a lot of companies that don’t

have covenants in their bonds, have little incentive

to uphold their financial circumstances,” said Bryan

Collins, a fixed income portfolio manager at Fidelity.

“there are other companies in the high yield space,

mostly in the dim sum market, that don’t have

covenants, nor do they have credit ratings or debt

instrument ratings. there are no safeguards for the

investors of this debt.”

Fidelity research indicates that 40%-50% of the entire

cNH bond market is unrated, though some debt has

been issued by a parent that does have a rating.

Further to that, 30% of all dim sum debt is classified

as high yield, or sub-investment grade, and it is this

category that is especially covenant-light. “effectively

all high yield dim sum bonds, give or take a couple,

have little-to-no covenants and have highly variable

terms and corporate structures,” said collins. “and

a lot of these also have no ratings, because these

companies know that if they sought one, they

wouldn’t be investment grade.”

this situation puts dim sum investors in a precarious

place, where they might not have a way of fully

knowing how healthy a company is, nor have options

to reclaim their investment without covenants to

protect them if a company’s health deteriorates.

Global Bio-chem, for example, does not have a credit

rating and did not seek one for its dim sum bond. yet

its covenants act as a legal protection method to

help investors despite its lack of ratings.

While Global Bio-Chem’s deal is small, one debt

capital market (DCM) head says that the lessons

learned during its ordeal are broadly applicable.

“there were certainly deals done in the very early

days that didn’t have ratings and covenants, but

the record for this has improved recently,” he said.

“These deals were done in the frenzy of speculation

that the renminbi currency would appreciate against

the dollar, but now there’s been an adjustment of

supply investors are more discerning of the instruments

that they buy. this is another event that will help to

promote the use of covenants.”

this may be met with resistance, however. Just as

investors are looking to protect themselves with the

use of covenants, high yield issuers will want the

freedom of not being beholden to them.

Yet in the end, fixed income sources says that the

investors will win, “because we are the ones lending

on behalf of our investors, the borrowers have to do

right by investors, otherwise we simply won’t buy their

bonds,” said collins.

“the message that we see here is that is this will be

just another step in the development of this market to

create better covenants and better structured deals,”

adds the DcM head. “this is a natural consequence

of the market and is a trend that has been very much

in place before Global Bio-Chem’s technical default.

clearly, this trend will continue to ensure that investors

are in better control of the risks that they are taking.”


Many offshore bonds issued by chinese companies are both structurally and legally subordinate to their onshore debt, a problem which in theory can be mitigated by guarantees, keepwell agreements and letters of support. But the legislation in place to protect offshore investors is not always as robust as it may appear.

Due to China’s stringent capital controls, entities incorporated in china with cash flows generated from China must issue offshore bonds via an offshore vehicle.

this offshore vehicle often takes the form of a holding company (also known as the offshore parent company) that owns an equity stake in the onshore operating company. as such, offshore bond investors are not direct creditors of the onshore operating company. this means that they are both structurally and legally subordinate to onshore bondholders.

if the onshore company defaults or there is a problem with the offshore bond, investors can only file a case against the offshore unit which may be no more than a shell company. this can create legal challenges for investors.

equally, it is often unclear whether or not foreign law is enforceable onshore. “When you try to take that judgement to the chinese jurisdiction, the enforceability of such is questionable. So that’s one kind of issue that we have to realise if we are an offshore bondholder,” said Elizabeth allen, director and head of credit research for Asia Pacific at HSBC Global Asset Management.

equally, if a company in china falls under duress, onshore creditors are closer to it, both legally and physically.

“in a situation where a chinese bond issuer is in financial difficulty, their local creditors are so much closer to the operations and assets to claim their money first. Whereas here we are offshore, we try to enforce our rights through various mechanisms offered to us under the bond indenture. Who gets the money first?” added Allen.

Guarantees?

this disparity between the rights of onshore and offshore investors can theoretically be minimised if the offshore bonds are guaranteed. For chinese companies issuing offshore, a guarantee can take several forms. the most effective would be a guarantee from the onshore operating company.

“as a bondholder, in an ideal scenario, you would like to have recourse to these guys [the onshore operating company]. But that never happens in dim sum bonds. What instead happens is that the [onshore] parent company has a shareholding in the offshore parent company which is the guarantor of the bond. So this guarantee really doesn’t mean too much to us. Because none of these [offshore] entities really have assets, for the most part,” said Sabita Prakash, head of fixed income for asia at Fidelity Worldwide investment.

other forms of guarantees include keepwell agreements and letters of support.

DIM SUM BOND GUARANTEES WOULD NOT WITHSTAND A DEFAULT


Keepwell agreements are contractual obligations between the supporting and the supported company that guarantee continued financial support in the case of default.

However, the bondholder has no direct recourse to the onshore company and the contract does not protect bondholders specifically, but includes all senior debt investors.

“the keepwell agreements are nice to have. the issuers may like to think that they are almost as good as guarantees, but in reality they are not,” said allen.

in addition, keepwell agreements do not have approval from china so it is uncertain whether or not they would work in practice. letters of support are perhaps even less effective as they are not legally binding, and the only negative repercussion of breaking one would be the bearing on the company’s reputation.

“there are some deals where it seems that there is no structural subordination because of these structures. Our argument is that it’s not straightforward and for the most part, in fact almost 100% of the cases, it is not certain and it’s not proven that structural subordination concerns can be overcome,” said prakash.

a third way of guaranteeing offshore bonds is support through intergroup transactions. the idea is that in times of trouble, companies can move money between different units without approval from the regulatory authorities.

“a lot of them have resorted to extremely complicated structures and tried to convince bondholders that without regulatory approval they can go through with intergroup transactions and keep bondholders protected and keep them safe,” said prakash.

“[But] there are so many points of failure and so many uncertainties as to whether the regulator will really allow this company to buy these shares without approvals.”

Buyer beware

even in some of the more recent offshore deals, where all of the necessary guarantees seem to be in place, some commentators argue that practical issues will remain even if the legal ones are resolved.

“Recently some Soes have done deals with offshore credit with a guarantee from an onshore creditworthy entity. the issue there is practical not legal,” said alec tracy, partner at Skadden, arps, Slate, Meagher and Flom.

“[the guarantees] should be enforceable with pRc government approvals properly in place. But it’s a practical question as to how would you enforce [a guarantee]. the short answer is that the chinese courts are unlikely to enforce an offshore judgment. So more likely than not you’re going to have to start a new case in china.”

By which stage, he argues, the onshore creditors will likely have absorbed all of the remaining value of the company. Because of the low chance of reimbursement in the case of a default, investors in the offshore bond market are often willing to allow companies to break their covenants.

“if the companies go ahead and breach those covenants, the bondholders would have the right to enforce their bonds if they find out about it, but [in] the offshore bond market for china-based business there are a number of companies that have gone over the limits in their violation of their covenants and often nothing happens,” he said.


this means that investors must evaluate the fundamentals of each company much more closely than in other markets where covenants and guarantees are enforceable.

“Without a proper guarantee, we have to think about how a company fits into a group and what is the incentive or reason for the rest of the group to support it. this is highly judgmental,” said allen.

“investors have to evaluate the strength of the company that is providing the protection, as well as the willingness of that company in standing behind the protection that they are providing. More often than not, it is a judgment [as to whether] the credit quality of the issuer is indeed enhanced by these measures,” said Suanjin Tan, director and Asia fixed income portfolio manager for BlackRock based in Singapore.

the presence of structures such as letters of support and keepwell agreements shows that issuers are earnest about showing the parent company has every intention of supporting the operating company or the issuer of the debt.

But more measures could be taken in order to minimise the disparity between offshore and onshore bondholders.

“the ideal scenario is of course for offshore investors to be pari passu with onshore creditors. other sorts of protection could be where an issuer has significant offshore assets or bank accounts/receivables can be pledged as security to the issue,” said tan.

“as we see more instances of onshore companies issuing directly from the onshore operating company and that offshore investors are pari passu with onshore creditors, that will go a long way towards removing the structural subordination issue.”

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Defaults, breaches & covenants in offshore RMB bonds

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