China Builder Default Shakes Faith in $72 Billion Bond Enhancers

  • Some $11.5 billion of bonds are sold with keepwell deed in ’16
  • Legal validity of keepwell deeds is being tested: Nomura

The faith that international investors have put in some credit sweeteners on Chinese debt is being tested with the latest default from one of the nation’s builders.

China City Construction International Co., whose recent shareholder change triggered early redemption of its debt, failed to make full payment due June 20 on its 5.35 percent 2.5 billion yuan ($377 million) Dim Sum notes with an original 2017 maturity, people familiar with the matter said last month. Its parent China City Construction Holding Group Co. provided a so-called keepwell deed, which is a commitment to maintain the issuer’s solvency while stopping short of guaranteeing payments.

Concerns are mounting about the creditworthiness of Chinese companies as the nation grapples with the world’s biggest corporate debt loads and a slowing economy. Local corporate defaults have jumped in the past two years and even overseas securities from the country’s borrowers have lost money, including the first default by a Chinese developer on dollar notes last year. That comes amid $11.5 billion of Chinese securities sold with keepwell agreements this year, bringing the total outstanding amount to $71.6 billion, according to data compiled by Bloomberg.

“China City Construction’s default reveals the problems with unique credit enhancement structures such as keepwells,” said Ivan Chung, head of Greater China credit research at Moody’s Investors Service in Hong Kong. “It dealt a blow to the faith investors have in such credit enhancements.”

The management of China City Construction cited cross-border fund remittance issues for the default, people familiar with the matter said in July.

A spokesman at China City Construction International who didn’t wish to be identified due to company policy declined to comment, while two calls to the onshore parent went unanswered.

Given that the Dim Sum notes are not guaranteed by the onshore parent, offshore bondholders can’t sue the parent in a domestic Chinese court the same way the onshore creditors can, according to a Moody’s report dated July 28.

“We have had reservations about keepwell agreements because we are not sure if and how onshore courts will accept or deal with lawsuits on non-payment,” said Moody’s Chung.

Uncharted Waters

The legal validity of keepwell deeds, which are essentially gentlemen’s agreements, is untested because no such notes had defaulted before, said Anthony Leung, credit analyst at Nomura Holdings Inc. in Hong Kong. “The China City Construction default will be a test case in terms of how the restructuring will play out.”

Without a direct onshore guarantee, issuers are limited from transferring funds offshore to repay debts any time they want, according to Standard Chartered Plc.

“The complication this time is about the still restrictive capital account in China," said Becky Liu, Hong Kong-based senior rates strategist at the bank. "Even if issuers have the willingness to pay, the current regulatory framework might not allow the money transfer under the keepwell structure.”

Discernment Needed

Investors should be discriminating about note issuers as well as keepwell providers, according to China Merchants Bank Co.

“Though the first default has happened with such a structure, investors shouldn’t shun all such bonds,” said Liu Dongliang, a Shenzhen-based analyst at the bank. “They should separate the good-quality issuers from the bad ones.”

Even after rule changes last year on some overseas bond offerings, many companies are still selling notes under the keepwell structure largely because of existing programs such as medium-term notes and the fact that doing so is faster than with guarantees, Moody’s Chung said. Most of the Chinese local financing vehicles are also using such credit enhancements to sell offshore bonds.

“This default could lead to a more cautious sentiment toward keepwell bonds overall and investors will likely be more selective,” said Angus To, a senior research analyst of ICBC International in Hong Kong. "As result, they are likely to prefer issuers with sounder fundamentals and better track records of repayment history."

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