China real estate companies have been enjoying their new found access to the onshore bond market this year with issuance of around Rmb177bn ($28bn) so far, compared with just Rmb12bn in 2014.
Firms had been restricted from accessing the market for nearly six years, but a slowing economy prompted China to relax the rules in June 2014 to ease the industry’s funding pressure.
The attraction of the onshore market is not hard to see. It is cheaper than the dollar bond market, for example, with headline savings of up to 750bp on coupons. And with most Chinese property companies having domestic projects, issuing renminbi onshore prevents any currency and asset mismatch, while it also helps firms overcome pesky capital controls.
So far, bond investors have been more than happy to gobble up the glut of new supply. And issuance is only set to pick up, thanks to the sector being one of the chief beneficiaries of China’s recent monetary loosening.
But while frenzied debt purchases are keeping the market going, investors need to be aware of the fact that buying domestic bonds could turn out to be a risky proposition.
One of the main problems is the lack of credit differentiation as almost half the onshore bonds are rated triple A – the highest possible rating provided by domestic agencies.
This is a particular problem for the Chinese property sector as most firms are actually viewed as high yield internationally. Yet domestically, the same group of issuers are seen as the safest credits. Beijing Capital Land, Guangzhou R&F Properties and Evergrande Real Estate, for example, are respectively rated BB, BB and BB- internationally, but AA+, AA+ and AAA domestically.
The disparity poses the question of whether investors are actually buying into a credit that is far shakier than their triple A rating suggests – and are not being duly compensated for it.
It could simply be down to a difference in rating methodology, but surely even that cannot explain why Evergrande is able to achieve a 5.38% coupon for a five non put three offering onshore when it has to pay 12% for a similar deal offshore. These are things that investors need to look into.
In a developed market, a credit rating is just one of many ways for an investor to assess the risk they are buying. It is there to provide a second opinion, rather than dictate choice.
But China’s domestic bond sector is less market driven than in more developed economies. The onshore market only saw its first default in March 2014 when Shanghai Chaori Solar paid just a small part of its interest payment.
Since then, there have been just four other defaults. But it’s fair to say that the concept of risk, or a deal failing outright, is not one that is well understood in the country.
If they haven’t done so already, investors need to start sourcing extra opinions on Chinese property credits. International rating agencies would be a good place to start given their longer history of assessing real estate companies.
It’s also worth remembering that the depreciating renminbi poses an additional challenge to the credit profile of property developers, given their substantial foreign currency debt exposure. The weaker the renminbi gets, the more pressure it puts on their ability to servicing foreign debt.
Undoubtedly, the potential of more onshore fundraising is huge. The authorities have capped total onshore public bond issuance to 40% of a developer’s total net asset value. And most companies are yet to reach half that limit.
But if investors don’t tread with caution and re-think the way they view risk, the aftermath can be damaging, and the market may well have to face yet another painful correction.