Does a high-yield debt market exist in China?
Generally, high-yield debt consists of securities (mainly corporate bonds) rated below BBB– or Baa3 by established international credit rating agencies. Issuers rated below investment grade are considered to have a greater risk of defaulting on interest or principal repayments and, therefore, are generally expected to pay higher coupons to investors. However, unlike most other debt capital markets, the domestic high-yield debt market in China (which for the purpose of this chapter excludes Hong Kong, Macau and Taiwan) is not well defined. This is because the rating scales used by the Chinese credit rating agencies are not comparable to those of international credit rating agencies, and the Chinese regulations require publicly offered debt securities to have a rating of AA or above. Market statistics suggest that over 90 per cent of bonds fall into only three rating categories: AAA, AA+ and AA. The vast majority of domestic bonds are rated AA or above, which means Chinese credit rating agencies pool bonds with different credit risks into the same broad rating categories, raising doubts over the accuracy of Chinese ratings. Bond default cases in recent years did not imply significant differentials among bonds with different domestic ratings. According to the data compiled by Wind Information, a Chinese financial data provider, the total number of domestic bonds default cases reached 714 as of the end of 2020, involving 184 issuers. Most of these issuers were rated AA and above before defaults. Compared to the domestic market, Chinese issuers are active in issuing debt offshore and have been dominant in Asia’s G3 bond market in recent years, providing high volumes of bond products across a range of different ratings and maturities, including high-yield debt. Despite the challenges relating to onshore regulatory requirements and fast-changing market conditions, Chinese issuers’ demand for offshore high-yield bond offerings remained high, though volatile, in recent years, and there was a boom in high-yield bond offerings by Chinese real estate developers at the beginning of 2019.
The overall approach of Chinese issuers’ offshore high-yield offerings is very similar to that in the high-yield markets in the United States or Europe. Nonetheless, differences remain in certain areas, including significant carveouts and exceptions from the basic covenants. Most high-yield bonds issued are typically denominated in US dollars and governed by New York law. The covenant packages have been modified to adapt to the conditions of the Chinese companies and their needs, driven by factors such as regulatory requirements, the issuers’ business in China and the appetite of the market participants.
Overview of China’s domestic debt capital markets
The Chinese domestic debt capital markets consist of the interbank bond market and the exchange market (consisting of the Shanghai Stock Exchange and the Shenzhen Stock Exchange). Debt securities offered and traded on different markets are subject to different regulatory regimes, as follows:
- debt securities issued by financial institutions (financial bonds) and primarily offered and traded on the interbank bond market (with limited exceptions) are regulated by China’s central bank, the People’s Bank of China (PBOC);
- debt securities issued by corporate entities that are not financial institutions and offered and traded on the interbank bond market (debt financing instruments of non-financial enterprises) are regulated by the National Association of Financial Market Institutional Investors (NAFMII), a self-regulatory body under the supervision of the PBOC;
- debt securities offered and traded on the exchange market are regulated by the China Securities Regulation Commission (CSRC) and the relevant stock exchanges; and
- ‘enterprise bonds’ (bonds issued by corporate entities that are not financial institutions and offered and traded on both the exchange market and the interbank bond market) are regulated by the National Development and Reform Commission (NDRC) and China Central Depository & Clearing Co, Ltd (CCDC).
The regulatory approval, registration and offering process
Debt security issuance (regardless of ratings) in China is subject to stringent regulatory approval or registration requirements, as follows:
- the PBOC’s approval is required for financial bond offerings;
- registration with NAFMII is required for offerings of debt financing instruments of non-financial enterprises;
- review by the stock exchange and registration with the CSRC are required for public offerings of debt securities on the exchange market;
- a post-issuance filing with the Securities Association of China, a self-regulatory body under the CSRC’s supervision, is required for private placements on the exchange market; and
- review by CCDC or NAFMII and registration with the NDRC are required for enterprise bond offerings.
To complete the respective regulators’ registration procedures or obtain consent, the issuer is required to prepare and submit to the regulators the required application documents, with assistance from the lead underwriters. Although the application documents vary for different types of debt securities regulated by different regulators, most of the regulators require, among others, the following documents (regardless of the credit standing of the issuer):
- an application letter or registration report (as applicable);
- the resolutions of the issuer’s board of directors or share- holders’ meeting;
- the issuer’s articles of association and other constitutional documents;
- the offering circular;
- audited financial reports for the past three years and the latest financial period;
- credit rating reports (if applicable);
- a repayment plan (if applicable);
- legal opinions;
- credit enhancement documentation (if applicable);
- an underwriting agreement (if applicable);
- a trustee agreement (if applicable); and
- leading underwriters’ recommendation letters (if applicable).
After the respective regulators give registration or consent (other than for private placements on the exchange market), the offering can be launched. Price enquiries with potential investors are generally permitted. However, in most offerings, pricing is conducted through a central book-building (similar to a Dutch auction) or a bidding process pursuant to regulatory requirements.
Main participants in China’s domestic debt capital markets
In addition to the issuer, the key participants in debt offerings (whether investment grade or high yield in China’s domestic markets) include the following:
- Lead underwriters, which are qualified financial institutions possessing the requisite underwriting licences. Generally, only lead underwriters execute an underwriting agreement with the issuer and have underwriting commitments. Syndicate members act like dealers and do not enter into the underwriting agreement directly with the issuer.
- Auditors, which are qualified accounting firms that have audited the issuer’s financial statements.
- Rating agencies, which are qualified credit rating agencies overseen by the Chinese regulators.
- Law firms, which are Chinese law firms possessing the requisite qualifications to advise on the respective debt offerings. The issuer must engage counsel to issue a legal opinion for the application to the respective regulators for approval or registration of the debt offering. Most lead underwriters do not engage counsel to advise them on domestic debt offerings.
- Bond custody and clearing institutions. Debt securities issued on the interbank bond market are registered with, under custody of, and settled and cleared through CCDC or Interbank Market Clearing House Co, Ltd (also known as the Shanghai Clearing House). Debt securities issued on the exchange market are registered with, under custody of, and settled and cleared through China Securities Depository and Clearing Corporation Limited.
- Post-issuance managers (for debt securities issued on the inter- bank bond market) or trust managers (for debt securities issued on the exchange market). This role, unlike a trustee or fiscal agent on other markets, is generally taken by the lead underwriter of the debt offering and the underwriter is expected to monitor the issuer on its performance of ongoing obligations until the maturity of the debt securities.
Investor protection Covenants package
In other markets, high-yield debt documentation generally contains protective clauses, including significant covenants, in the terms and conditions of the bonds. To protect investors’ interests, a high-yield debt issuer is typically requested to make a number of undertakings to ensure that its financial condition, business and assets remain within certain limits, such as limitation on asset sales, incurrence of indebtedness, creation
of liens, restricted payments and transactions with affiliates, and cove- nants on dividends, mergers and certain other covenants. Traditionally, the terms and conditions of debt securities in China’s domestic markets have been relatively thin. A covenants package contained in the terms and conditions of high-yield debt securities offered in other markets was rarely seen in China’s domestic market until the recent defaults on corporate bonds.
In April 2019, NAFMII issued a set of sample investor protection provisions, including cross-default clauses, a variety of covenants packages, undertakings and negative pledges, and change of control put options. The triggering of the events listed in these provisions does not necessarily lead to a declaration of default. Rather, the specified remedies shall apply (eg, the exercise of the change of control put options) or a bondholders’ meeting shall be called to discuss solutions, which could be the early redemption of the bonds, the provision of guarantees or collateral, or a waiver of default. In September 2020, NAFMII issued a new set of sample investor protection provisions for the inclusion in offering circulars, which incorporates the 2019 version of the sample investor protection provisions and expands the sample terms to cover bondholders’ meetings, trust managers, events of defaults, remedies and risk resolution.
A bondholders’ meeting is a common investor protection mechanism in China’s domestic debt capital markets. Issuers are generally required to include a bondholder meeting provision as part of the terms and conditions of their debt securities. This provision may refer to the relevant rules governing bondholders’ meetings, or set forth the procedures for calling bondholders’ meetings, the quorum, voting requirements, adjournment, written resolutions and other matters relating to bondholders’ meetings.
NAFMII has released a rule governing bondholders’ meetings for debt financing instruments of non-financial enterprises, providing concrete procedural rules for bondholders’ meetings and a descriptive list of triggering events for calling these meetings. The CSRC regulation governing corporate bond offerings on the exchange market also provides a list of triggering events, upon the occurrence of which a bondholders’ meeting must be convened.
However, in practice, the effectiveness of bondholders’ meetings in protecting investors’ rights and interests is questionable. There have been a number of cases when the issuer has refused or failed to implement the resolutions from bondholders’ meetings, particularly those requiring the issuer to redeem the bonds early or to provide an additional guarantee or collateral, and investors were left with no redress other than to sue the issuer.
Ongoing disclosure requirements
For debt securities issued in China’s domestic market, whether investment grade or high-yield debt, traded on the interbank bond market or the exchange market, the issuers are required to make ongoing disclosure during the life of the debt securities. Ongoing disclosure consists primarily of the following two categories:
- Periodic disclosure, including audited annual financial statements and unaudited interim (in most cases, quarterly) financial statements.
- Disclosure of material events. The NAFMII rule setting out the information disclosure requirements for debt financing instruments of non-financial enterprises specifies certain types of material events that must be disclosed by the issuer in a timely manner. The CSRC regulation governing corporate bonds traded on the exchange market also requires issuers to disclose the specified types of material events in a timely manner. These material events, the occurrence of which may materially and adversely affect the issuer’s repayment ability, include (whether in NAFMII’s rule or the CSRC’s rule), among others:
- material changes to the issuer’s business strategies and operating environment;
- default in the payment of debt;
- incurrence of significant debt;
- encumbrance or freezing orders over its material assets;
- waiver of creditor’s rights for a significant amount of debt owed by third parties;
- criminal proceedings or significant investigations against any director, officer or supervisory board member;
- material legal or arbitral proceedings or regulatory penalties;
- significant losses exceeding 10 per cent of the issuer’s net assets; and
- institution of a bankruptcy or liquidation proceeding; or merger, separation or reduction in registered capital.
Additionally, rating agencies are required to monitor the issuer’s credit status during the life of its debt securities and release a follow-on rating report at least annually.
Offshore offering structure
A typical Chinese high-yield issuer has an offshore holding company in the Cayman Islands or Bermuda that may be listed on the Hong Kong stock exchange, has several intermediate companies organised in the British Virgin Islands or Hong Kong and has substantial onshore operations. In recent years, certain Chinese companies listed in the domestic stock exchanges have also entered the offshore high-yield market.
The high-yield bonds issued by Chinese issuers are typically governed by New York law. Key documents in the high-yield offerings include, among others, the description of notes in the offering memorandum, indenture, global notes and the purchase agreement. Depending on the offering structure, transaction documentation may also include security documents, inter-creditor agreements, escrow agreements and any third-party waivers or consents.
In the process of tapping offshore bonds markets for raising funds, Chinese issuers have adopted various transaction structures that suit their needs under different circumstances. Specifically for high-yield bonds, two transaction structures are most often seen in the current market: the direct issuance of bonds by a Chinese issuer (the direct issuance structure); and the issuance of bonds by an offshore special purpose vehicle with a cross-border guarantee provided by its onshore parent (the cross-border guarantee structure).
With the growing liquidity of the Asian market in recent years, most of the Chinese issuers’ high-yield bond offerings are offered in accordance with the exemption under Regulation S of the US Securities Act of 1933, as amended (US Securities Act). This led to a shortened time- table to execute a high-yield transaction. A few years ago, when the Asian high-yield bond market was largely driven by US institutional investors, Chinese issuers offering high-yield debt offshore had to conduct their offerings in accordance with Rule 144A under the US Securities Act.
Regulatory approval and registration
Over the past years, the Chinese regulatory authorities have continually amended the relevant regulations in respect of offshore bond offerings by Chinese issuers in response to changing domestic and international economic conditions.
Following the promulgation of the Circular on Promoting Reform on the Administration of Filing and Registration of Foreign Debt by Enterprises (the Circular) by the NDRC on 14 September 2015, the case-by-case approval requirement for offshore debt issuance by onshore Chinese companies was replaced by a procedure under which issuers are required to complete pre-issuance registration with the NDRC of offshore bonds with a tenor of more than one year and complete a post-issuance filing with the NDRC within 10 working days after closing.
The NDRC pre-issuance registration and post-issuance filing requirements apply to offshore high-yield bond issuances by onshore Chinese companies, as well as the offshore subsidiaries controlled by onshore Chinese companies and, therefore, would be required under both the direct issuance structure and the cross-border guarantee structure. Since 18 February 2019, the central NDRC requires all Chinese issuers to complete pre-issuance registration and post-issuance filing with the central NDRC directly. Since 1 November 2020, all applications for NDRC pre-issuance registration are required be made through an online system developed by the central NDRC. Although it is provided in the Circular that the NDRC will decide to accept a pre-issuance registration application within five working days from the date of application, and issue a registration certificate within seven working days from the date of acceptance, the NDRC has discretion to conduct a substantive review of the application to ensure compliance with the eligibility requirements provided in the Circular and this timeline is, in practice, rarely strictly followed by the NDRC. Therefore, registering an offshore bond issuance at an early stage of the transaction is always advisable to ensure certainty in the deal execution. Depending on certain factors concerning the Chinese regulators, at times it is relatively easy to get approval and at other times it is quite difficult, as NDRC approvals swing between a constrained supply and a supply glut. This has resulted in certain offerings being driven by NDRC approvals more than the issuers’ own needs. Once an issuer receives a quota, then in many cases, they want to complete the offering before the expiry date, which may result in a rush to the market before the calendar year end.
On 9 July 2019, the NDRC issued Circular 778, which, aiming to strengthen the management of foreign debt issued by Chinese real estate developers, expressly restricts the use of proceeds from foreign debt securities issued by Chinese real estate developers to repay their existing medium and long-term foreign debt due within one year. This has effectively capped the overall size of foreign debt of a Chinese real estate developer at its existing level and closed the door for the issuance of offshore high-yield bonds by Chinese real estate developers that have no existing foreign debt.
Offshore high-yield bond issuances by Chinese companies under either the direct issuance structure or the cross-border guarantee structure are subject to the registration requirement imposed by the State.
Administration of Foreign Exchange (SAFE)
A SAFE non-registration put is normally included in the terms of offshore high-yield bonds issued by Chinese issuers, either under the direct issuance structure or the cross-border guarantee structure. If the SAFE registration is not completed by a certain deadline as set forth in the terms of the high-yield bonds, then investors in these bonds would have the right to require the issuer to repurchase the bonds at par plus the accrued interest until, but not including, the date of repurchase.
According to the Administrative Measures for Foreign Debt Registration issued on 28 April 2013 and its relevant implementation guidelines, Chinese issuers opting for the direct issuance structure shall complete registration with the local SAFE within 15 working days of the execution of the transaction documents that incur foreign debts. The information relating to this bond issuance may also need to be filed at the local SAFE pursuant to the Circular on Relevant Matters about the Macro-prudential Management of Cross-border Financing in Full Aperture issued by the PBOC, which came into effect on 12 January 2017, if the Chinese issuer is not a real estate developer or local government financing vehicle.
For offshore high-yield bonds issued under the cross-border guarantee structure, the onshore parent guarantor would be required to register the cross-border guarantee for the high-yield bonds in accordance with the Provisions on the Administration of Foreign Exchange for Cross-Border Security and the Administration of Foreign Exchange for Cross-Border Security Implementation Guidelines promulgated on 19 May 2014 (the Cross-Border Guarantee Registration Rules). Under the Cross-Border Guarantee Registration Rules, a Chinese onshore corporate or entity can provide a cross-border guarantee to support debt securities issued by an offshore entity, provided that the Chinese onshore guarantor has a certain equity interest in the offshore issuer, and shall register this cross-border guarantee with a local SAFE within 15 working days after the execution of the guarantee. It generally takes a few months for the local SAFE to complete the registration of the cross-border guarantee.
The Cross-Border Guarantee Registration Rules impose restrictions on remitting any proceeds from offshore bond issuances with onshore cross-border guarantees back into China and require the proceeds raised from this issuance to be used outside China for offshore projects verified by the NDRC. However, this restriction has been lifted by the Notice on Improving the Check of Authenticity and Compliance to Further Promote Foreign Exchange Control issued by SAFE on 26 January 2017. The cross-border guarantee structure has since become increasingly popular with Chinese issuers of offshore bonds offerings and international financings.
Chinese issuers’ high-yield bonds are typically issued with full high-yield covenants. These covenants are originally inherited from US high-yield bonds with carveouts and exceptions that have been evolved over time. One unique feature of high-yield bonds issued by Chinese issuers is structural subordination. The method to pledge hard assets as collateral is typically not available for Chinese companies that are structuring offshore transactions, because Chinese regulations restrict the shares and assets of onshore operating companies from being pledged as security for offshore debt. Consequently, the shares of offshore intermediate holding companies are pledged instead. Given offshore noteholders’ lack of ability to control the onshore Chinese operating companies’ assets and revenues, some high-yield bond offerings by these Chinese issuers have omitted share pledges. Similarly, China-incorporated onshore entities that possess substantial assets or operations can only act as non-guarantors and may not provide guaran- tees for the transaction.
Offshore noteholders only receive subsidiary guarantees from non-Chinese subsidiaries, which typically account for only a nominal amount of the issuer’s assets. This structural subordination greatly limits the noteholder’s access to onshore assets and places offshore creditors at a significant disadvantage to onshore lenders in a default situation. As a result, the covenants package is designed to minimise the incurrence of onshore debt that is structurally senior to the offshore high-yield bonds to the extent it is possible.
At the early stage of Chinese issuers’ issuing high-yield debt, the covenants package was quite tight. As time has passed and investors are more familiar with these Chinese issuers, there is a general trend towards loosening the covenants package. Meanwhile, owing to business growth in China and the increased complexity of the issuers, many high-yield issuers require substantial flexibility, which has further driven changes in the covenant packages. For example, certain carveouts under the debt covenants were introduced to permit these issuers to incur substantial additional onshore debt through purchase money, trust financing, investment properties and other exceptions tied to a percentage of total assets that grows with the business.
Main participants in Chinese issuers’ offshore high-yield offerings
Major participants in Chinese issuers’ high-yield debt offerings include issuers, investment banks, legal counsel, auditors, trustees and, depending on the structure, there might be other relevant parties, such as subsidiary guarantors, parent guarantors and collateral and escrow agents.
One feature is that Chinese issuers’ high-yield deals are concentrated in the real estate sector. Chinese real estate developers substantially dominate all the offerings of Chinese issuers’ high-yield debt; although, in recent years, some non-real estate developer issuers have come to the market. This concentration is largely relevant to the onshore financing capabilities of Chinese real estate developers. In addition to the general macroeconomic conditions, foreign exchange fluctuations, and investors’ yield expectations, Chinese real estate developers’ ability to access onshore loan and bond markets are often limited owing to policy concerns and changes in regulatory requirements.
Chinese issuers are naturally attracted to the onshore financing market when it is cheaper for them because the proceeds are used to finance onshore projects. For example, during 2015 and the first half of 2016, the Chinese offshore high-yield debt market experienced a slowdown with the liberalisation of the onshore market. However, when the regulations are tightened, Chinese high-yield issuers come back to the offshore market to issue high-yield bonds. As a result, the high-yield offering volume of Chinese real estate companies has been volatile.
Another feature for market participants is that the mix of under- writers and investors for Chinese high-yield bonds has changed significantly in recent years. New players with China-based parents, both underwriters and investors, have entered the market. Investor demand is increasingly coming from the Hong Kong branches or subsidiaries of Chinese banks, insurance firms, securities firms, asset management firms or Chinese companies that have offshore treasury units. Chinese investment banks are competing with global investment banks to win more underwriting business in the Chinese issuers’ high-yield debt offerings and they are reasonably successful. Chinese investment banks, such as China International Capital Corporation, Guotai Junan Securities, Haitong Securities, China Securities International, China CITIC, BOCOM International, ABC International, CCB International, CMB International, Bank of China and China Everbright Bank, have come to feature repeatedly in the high-yield transactions and in the league table.
At the early stage, high-yield debt offerings were featured with one or two joint bookrunners, but currently, each deal seems to involve many joint bookrunners combining to form a big syndicate team.
Despite fluctuations in the past few years, the Chinese high-yield market is still a very sustainable market in terms of volume. The market will continue to broaden, in terms of the structure, type of issuers, type of other participants and an increased need for US dollar funds driven by the globalisation of Chinese companies. We believe that the onshore debt market would blend more with the offshore market if offshore creditors were able to access onshore collateral.