Investors question standby letters of credit in China
* Rise in bond issuance with guarantee causes concerns
* Reliability of the structure is still untested in China
* Rapid growth may prompt regulators to curb practice
By Neha d'Silva
HONG KONG, Oct 25 (IFR) - Institutional investors are beginning to question the use of credit enhancements on Chinese bond offerings, raising doubts for the future of an increasingly popular funding tool.
After an enthusiastic response to earlier deals carrying standby letters of credit, the reaction to this week's US$900m offering from unrated Chinese brokerage Haitong Securities was far less sanguine.
A standby letter of credit from Bank of China's Singapore branch helped Haitong draw orders of US$4.5bn from 280 investors for the five-year bond. It fixed the coupon at 275bp over US Treasuries, a level probably hundreds of basis points below where it would fund on its own.
Yet, the issuer had to pay a heftier premium over pure Bank of China risk than on previous deals that used the same structure. Citic Securities' 2018 notes, also backed with a standby letter of credit from Bank of China, were quoted at 230bp over Treasuries. They were issued at 185bp over Treasuries in April.
Investors do not necessarily doubt Bank of China would honour the letter of credit if Haitong were to default. However, given the lack of a track record for restructurings with such guarantees and the fact that foreigners have no recourse to onshore assets according to Chinese law, they have started to demand a higher premium for bonds that come with standby letters of credit.
"While the instrument itself is not new, we have not seen the structure tested in the bond markets," said Sabita Prakash, head of Asian fixed income at Fidelity Worldwide Investment.
The pace of issuance is also causing some concern. Some Chinese bankers have expressed fears that the widespread use of the format may prompt local authorities to clamp down on it to prevent risks from building up in the banking system.
Prakash shared that view. "If there was a runaway expansion in SBLC-backed deals, we should be worried. Therefore, we need to monitor the levels," Prakash said.
Offering a borrower a SBLC can be good business for the bank doing so. In China, the fee for the guarantee can run up to 300bp.
Technically, the bank still needs to set aside a capital buffer for the amount it is insuring, since Basel rules consider these agreements to be contingent liabilities and require full provisioning for them, as if they were loans.
However, the bank does not need to disburse any funds unless the company defaults on the obligation.
For the companies, the credit enhancement can mean significant savings in funding costs, even after the guarantee fee.
Haitong, for instance, would have had to pay a far higher coupon on its dollar bond if it had depended on its own creditworthiness - and it would not have raised such a large amount.
The structure has gained popularity in China in the past year since China Cosco, a government-owned company in the troubled shipping sector, raised US$1bn of 10-year debt in late November 2012 at a yield of only 4.152%.
That deal proved that investors were willing to invest large amounts of money at low yields in companies that they would otherwise shun, simply because of the guarantee.
It also proved to Chinese banks that they could help some of their key cash-strapped clients to refinance debt without having to lend directly to them.
Four other transactions followed, including one for ZhengTong Auto, a premium car dealer in China, which, unlike the other issuers, had no direct relation to the state.
The quickening pace of such deals and the increasingly risky profiles of the borrowers, though, has some bankers worried that Chinese authorities could crack down on the practice.
"I think ZhengTong was an odd case, bankers are getting more careful in granting SBLCs," said a banker from a Chinese institution. (Reporting By Neha d'Silva; editing by Christopher Langner and Steve Garton)
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