Markets

Christopher Langner is a markets columnist for Bloomberg Gadfly. He previously covered corporate finance for Bloomberg News, and has written for Reuters/IFR, Forbes, the Wall Street Journal and Mergermarket.

China's efforts to breed crude capitalism with state control have led to some strange offspring. In the bond world, the oddest have been so-called keepwell agreements. They may be about to go the way of the dinosaur, possibly triggering a rare reversal in the law of supply and demand -- as the securities become scarcer, they're likely to be even less appealing to global investors.

Keepwell agreements weren't invented in China, but they've become popular there since 2012, when Gemdale, a developer,  sold a large offshore yuan bond with this enhancement.

Chinese Comfort
Companies in China have increasingly resorted to keepwell agreements as a way to soothe wary investors
Source: Bloomberg

The agreements say, broadly, that the onshore parent will make every effort to keep the special-purpose vehicle that issued the bonds solvent. They are no more than letters of comfort. At most, they entitle creditors to accelerate the bonds in certain circumstances, but carry no weight in a Chinese court in case of bankruptcy. They owe their existence to the difficulties companies face sending money home that was raised overseas as debt.

The State Administration of Foreign Exchange used to allow companies to repatriate funds from IOUs chiefly through equity injections or shareholder loans. So Chinese corporations created holding structures to enable special-purpose vehicles based in the Cayman Islands, for example, to sell bonds and then send the money to the real owner in Shanghai or Shenzhen. Last week, SAFE called an end to that, announcing that all money raised from offshore bonds can be sent home. 

This means Chinese companies will have less incentive to sell bonds using offshore subsidiaries, and will have a lot more to explain if they do. With the operating company borrowing directly, there will be no need for letters of comfort -- so it's unlikely that much will be added to the $69.1 billion outstanding of securities with keepwell agreements.

Sudden scarcity won't make these bonds more desirable, however. There already are examples of companies that started off issuing bonds with keepwells and then sold the debt without them, but with an obvious dotted line to the parent. The preference is clear.

The Price of a Letter
China State Grid's euro bonds due in 2022 with a keepwell have consistently paid a premium of almost 20 basis points over bonds with the same maturity that have a straighter line to the parent
Source: Bloomberg

As China opens its doors and accepts its nature as a capitalist country, aberrations such as keepwells should disappear. They won't even be valuable as collectors' items, and certainly not worth a premium: good riddance.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Christopher Langner in Singapore at clangner@bloomberg.net

To contact the editor responsible for this story:
Paul Sillitoe at psillitoe@bloomberg.net