24 November, 2011
Are dim sum bonds going cold?
Dim sum bonds may look like a like tasty prospect, but investors need to think carefully about the motives of the issuers, as well as the level of protection provided by the bonds’ light covenant packages
Dim sum bonds sound almost too delicious for a financial debt product. Named after the popular bite-size food originating in southern China, they emerged in 2007 after the PRC government began to take steps to internationalise its currency and allowed the issuance of renminbi (Rmb)-denominated debt in Hong Kong.
Rmb bonds can be issued with any variety of terms, providing more flexibility for issuers than medium-term notes (MTNs) or certificates of deposit (CDs). Both of these products are better suited for companies that frequently need to access the capital markets, meaning they tend to be favoured by larger issuers with investment-grade ratings. (In fact, many international companies issued their dim sum bonds using their existing
According to the Financial Times, by September 2011 the Rmb had become a more popular currency for bond sales than the euro. Much of that growth was down to the rapid rise of dim sum debt, issuance of which now totals US$140 billion; in the year up to October 2011, US$11.3 billion was raised in this way (figures from Dealogic). The bonds have also provided a lucrative source of business for banks in the region: the FT has reported that the Bank of China was the biggest underwriter of dim sum debt for the month of October, and a spokesperson from Standard Chartered (the second-largest foreign underwriters of Rmb bonds) says the bank has seen issuers “from across the board”, including property, power producer, gaming and entertainment, food retail and car manufacturing.
For issuers, dim sum bonds can provide a way to get around China’s tough capital controls, and may also give foreign companies a means of gaining political and capital in mainland China. Despite a slow start, once international companies saw the benefits of dim sum bonds, issuances started to come thick and fast. US companies McDonald’s and Caterpillar were the first to jump on the dim sum trolley in 2010; European companies including Unilever, BP, Volkswagen and Tesco have since followed suit; and Japanese companies including Mitsubishi UFJ and Century Tokyo Leasing have also been seen sampling the market. Recently Luxembourg-listed L’Air Liquide became the first French company to issue dim sum debt (with Latham & Watkins and Linklaters providing legal counsel to the issuers and underwriters, respectively).
For Chinese companies, issuing Rmb bonds in Hong Kong provides huge financial advantages over raising funds on the mainland, where interest rates can be many times higher. Until recently, only PRC financial institutions and Hong Kong subsidiaries of Chinese companies were allowed to issue dim sum bonds, but new measures announced by Chinese vice-premier Li Keqiang have opened the market to other mainland companies. Baosteel has already taken advantage of the new rules and has won approval for the issuance of US$1 billion-worth of Rmb debt by the end of 2011.
Balancing act
The choices made by any investor essentially come down to the balancing of risks, but are the risks associated with dim sum bonds really worth the possible payouts?
While investors have become more and more enamoured with the possibilities offered by dim sum bonds, concerns have also been growing about the liquidity of the market. There is now a vast pool of the Chinese currency in Hong Kong, and a correspondingly high demand for a limited range of places in which to invest it. The small size of most dim sum bond issuances means there is little trading of them on the secondary market. This has led to well-known issuers being able to sell debt with surprisingly low yields: Unilever’s three-year dim sum bonds were issued at a rate of only 1.15%. International investors are clearly willing to take a gamble on the appreciation of the Rmb, but should circumstances change, they would be left significantly exposed.
There are also more general foreign exchange risks related to the internationalisation of the Rmb. This is dependent on its growing use outside China which should lead to an increased demand and a consequent increase in its value. But if the Rmb does not appreciate as much as expected, the payout may not be sufficient to meet investors’ expectations.
Interest rate risk should also be considered carefully.
“The domestic bond market in China is developing fairly rapidly and, as that market becomes more open, whatever premium difference there is between Rmb bonds in Hong Kong and in China might create risk as well,” says Brian Spires, a Hong Kong-based partner and securities specialist with Baker & McKenzie.
Investors are certainly enthusiastic about Rmb-denominated assets, but some analysts say they perhaps have not paid enough attention to the credit-related risks associated with the issuers behind the assets. So far, there have been a wide variety of issuers involved in the market, including Chinese and offshore financial institutions as well as corporates. Those issuers have a correspondingly wide range of credit ratings. There is clearly a danger associated with investing in bonds issued by less well-known companies with operations in China, some of which have low credit ratings, or no rating at all.
“Because the bond issues are generally not rated, investors should consider carefully the business and regulatory risks posed by the issuer's operations, particularly those companies with operations in China that are not publicly-listed companies and for which there is not a lot of information publicly available,” Spires says.
Another risk comes from the fact that most dim sum debt instruments are light on covenants.
“As the investor base is expanded to include more pension funds and other similar institutional investors, the covenant packages may be revised to match the expectations and requirements of these new institutional investors,” says Spires. This is mainly because a lot of investors are banks in Asia looking to invest in something that matches with the syndicated loans they already have. Analysts say that as the investor base of dim sum bonds changes to include more pension funds and so on, the risk will change as well.
“Unlike Asia or China high-yield bonds, where you get a lot of offshore subsidiary guarantees, in dim sum bonds you typically don’t,” adds Edward Lam, a partner of the corporate group in Skadden Arps Slate Meagher & Flom’s Hong Kong office. “So when there is a breach of bonds, you have to go after the issuer which is the holding company – to get close to the assets you will typically have to wind up a few levels of companies and you are structurally subordinated to any debt that may exist at the subsidiary levels.”
By contrast, if problems arise with high-yield bonds, it is the offshore subsidiaries which are giving the guarantees, meaning jilted investors can get to the assets much more easily. Dim sum bonds may also lack restrictions on asset sales and payment, with only minimal protection being offered in the shape of a negative pledge, minimum consolidated tangible net worth and maximum gearing.
The covenant-light nature of dim sum bonds arose because of the market situation at the time they were first attracting international interest: early issuers such as McDonald’s and Hopewell Highway Infrastructure had good credit and did not need to offer investors reassurance in the shape of subsidiary guarantees, but as the market rallied less creditworthy issuers also managed to push through deals without these features. A recent Debtwire article highlighted how “a flood of non-investment-grade issuers have taken advantage of the steaming dim-sum market to raise cheap funding” after Galaxy Entertainment Group issued the first high-yield dim sum bond in December 2010. This has led to questions being asked by professional investors worried about structures which are “rather loose”.
Politics as usual
Perhaps the most significant – and interesting – area of risk arises because of the nature of many dim sum bond issuers: most are either China-based or China-focused, which brings in a variety of regulatory issues.
On the positive side, recent regulations produced by the PRC Ministry of Commerce mean that foreign investors will no longer be required to bring in foreign currency to make investments in China, but instead can use Rmb directly. Most analysts believe this move will accelerate growth of the offshore Rmb bond market in Hong Kong, and elsewhere in the region.
“Before, we only knew you could only bring money in through capital investment, or shareholders loans. It’s now clearer as to how you can bring money in, as well as the procedures for approval,” comments Baker & McKenzie banking and finance partner Harvey Lau, who is based in Shanghai.
There are some loose ends to be tied up: it is still unclear whether shareholders loans need to be approved differently, who can approve them and whether they can be used to repay existing Rmb loans, and details of how proceeds can be remitted and used in China are also uncertain. It is expected that the People’s Bank of China will issue more detailed regulations covering these issues which will help streamline the process and should encourage more non-China based companies to issue bonds (as it would be an easier mechanism of using funds in China).
An area which is generating much more uncertainty is the unavoidably political nature of matters concerned with the internationalisation of the Rmb. The decision which led to Rmb bonds being issued in Hong Kong was a political one – in other words, dim sum bonds arose as a by-product of the Chinese central government’s decision to internationalise the currency. This could be seen as an executive decision, and one which could be reversed should government policy change. Political policy risk is, therefore, an ever present danger for investors. The decisions behind offshore Rmb bonds are not market driven, and could change relatively quickly should there be a change of cabinet in Beijing. These factors mean securities lawyers may find it hard to advise with the level of certainty which they would like.
“In China we often say that things are grey, and you have different degrees of grey,” Lau says. “Often times we don’t expect, and it is not possible, to be able to advise clients in a crystal clear manner. We can only say what we believe to be based on various factors such as what the market practice says, and what government officials say in a non-formal capacity.”
For Lam, however, the political risks presented by dim sum bonds are not so significant.
“China’s vice-premier Li Keqiang announced in August 2011 that it will encourage more Chinese companies to issue Rmb bonds in Hong Kong. The vice-premier said that Chinese companies will be allowed to directly issue bonds in Hong Kong, rather than through offshore subsidiaries,” he says “It’s unlikely that the regulatory environment is going to tighten so that it contradicts what’s been said before.”
Lam instead returns to the issue of the lack of subsidiary guarantees.
“You don’t get direct guarantees from PRC subsidiaries and you are exposed to debt incurred by the PRC subsidiaries in China,” he explains. (These debts could include onshore loans which would rank ahead of the bond investor.) Although these kinds of risks are, of course, present in any typical China high-yield deal, with dim sum bonds the investor also suffers because of a lack of covenants.
What lies beneath
Despite the risks, there is continuing investor interest and dim sum deals are being done relatively frequently, with more reportedly in the pipeline. A wide range of issuers – both corporates and financial institutions – have found dim sum bonds attractive enough to attempt an issuance over the past few years, and the advantages of issuing this kind of debt seem quite clear at first sight.
“Dim sum bonds attract a broad base of international investors, which will help bolster the issuer’s exposure and position in the global financial market. Proceeds raised from dim sum bonds can also be used to support the issuer’s Rmb-related businesses, helping an issuer to better manage its currency risk,” explains a Standard Chartered spokesperson.
But when you look more closely at the figures involved in some deals, it becomes harder to ascertain exactly why some issuers bothered.
When McDonald’s issued its dim sum bonds in August 2010 it raised around US$31 million – about enough to cover the corporation’s non-recurring operating expenses that year. There are several possible explanations for such a small issuance. One is that that money was cheap in those days (as mentioned, rates on dim sum bonds were sometimes set very low, and 2-3% was regarded as normal), and perhaps the company saw dim sum bonds as a low cost investigation into a new way of raising money.
Lam also points out that dim sum bonds could be an attractive way of raising money for a company with a capital expenditure requirement – one that requires capital for expansion in China, for example. The factors, mentioned above, that may make dim sum bonds risky for investors could work in the favour of this type of issuer.
“It won’t impose conditions on your operations, money is cheap, assets including shares in subsidiaries are often not pledged so you can give those to future lenders (so long as you provide for pari passu sharing with the Rmb bondholders as per the requirement of the negative pledge) … It allows a lot of flexibility to incur future debt and do future fund raising,” Lam says. “You don’t have the typical covenants, so there’s a lot of things you can do to your business – for example, you can sell assets, and you don’t have to buy replacement assets.”
Another explanation for McDonald’s diminutive capital raising is that the company simply did not have much need for Rmb, as it has access to a working capital line from PRC banks. This seems to contradict the view of the analysts who described the bonds as a means of financing McDonald’s plans for market expansion in China, for which no amount of Rmb could ever really be enough. Although foreign companies may have access to cash in China, it does not come cheap, as Rmb lending is subject to government-prescribed rates, which are generally unattractive compared with Hong Kong.
Yet another answer is that the company was looking for cheap publicity: a means of making its name known (although why a company with such high levels of brand recognition would need to do this is a question yet to be answered).
There is, however, another more intriguing hypothesis: some market rumours say McDonald’s issued the debt as means of gaining favour with the Beijing authorities. Aligning oneself with the central government’s policy aims is often recommended as a sound China strategy. For several years, there has been talk of foreign issuers being allowed to list in mainland China, and several international companies have indicated that they would like to be among the first to do so. Investing in Rmb bonds is certainly one way for a company to showing it is serious about this aim.
Where do we go from here?
Lam believes there is a future in dim sum bonds, but says that more and more deals will only get done in connection with investment-grade, or at least high-grade, issuers.
“Issuers with lower credit ratings, or that are highly geared, will have to live with high-yield bonds and typical high-yield structures,” he says, pointing to recent examples of real estate companies which have been unable to put through deals using typical dim sum covenant packages.
“Most end up using a high-yield package,” Lam continues. “A lot of these companies are highly geared – investors have a somewhat lower appetite for the real estate sector – and their credit rating is typically not as strong as for industrial companies.”
In September, Reuters reported that Malaysia's Khazanah Nasional was forced to delay its dim sum debut due to volatility in global currency markets and the consequent impact on the offshore Rmb arena. It quoted an unnamed trader as saying that “many investors buy dim sum bonds mainly for the currency and less for the yield.” If what this anonymous commentator says is true, and with global markets showing no signs of steadying any time soon, the future of dim sum bonds may not be so hot.
For further information, please contact:
Phil Taylor, Conventus Law