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Untested China bond structure sparks market angst after default

[HONG KONG] China's dollar bond market faces a fresh test after a landmark default by a private sector champion is set to trigger the first drawdown of a letter of credit for a public Asian bond.

China Minsheng Investment Group Corp (CMIG) said last week debt problems at its affiliate triggered cross-default clauses on its notes including a US$300 million bond, which carries a standby letter of credit (SBLC) from China Construction Bank Corp. According to CMIG's bond document, the SBLC may be drawn down under an event of default, which includes cross-default.

A failure or even a delay in payments with such a structure would be a further blow to China's bond market that's reeling from a spate of debt woes afflicting some of the country's big conglomerates. Chinese issuers have about US$7.3 billion of dollar notes outstanding that carry SBLCs, accounting for about 90 per cent of such greenback bonds issued globally, according to Bloomberg-compiled data.

This isn't the first test case on credit enhancers for Chinese dollar bonds, which helped weaker issuers raise over US$100 billion of notes from foreign investors. Keepwell provisions, a commitment to maintain an issuer's solvency but stops short of a payment guarantee from the parent, had its first test last May when two Chinese issuers defaulted on dollar notes. There has yet to be any resolution to the two cases.

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In the loan market, a SBLC is a strong credit booster as the issuer of the letter is expected to "irrecoverably and unconditionally" honour its obligations within a pre-agreed grace period if the borrower is unable to repay the debt, according to David Lam, a Hong Kong-based partner of King & Wood Mallesons. However, when it comes to bonds, the logistics of the payments are yet to be tested and some investors expect it may take a while to get paid.

"Unlike the Chinese private loan market where there have been precedents of SBLC being triggered, we are in uncharted water for SBLC-backed bonds," said Desmond How, head of fixed income at GaoTeng Global Asset Management. "My concern is less on the big Chinese banks honouring these agreements, but more on the process of enforcement which could be onerous and protracted."

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JPMorgan Private Bank reckons investors should start demanding more premiums on SBLC-backed bonds due to the potentially long enforcement process, although a failure might be unlikely. A delay could occur when investors and trustees study the situation and eventually ask the SBLC-provider to repay the bonds, said Anne Zhang, executive director for fixed income, currencies and commodities at the bank.

China Construction Bank's media department didn't immediately reply to an email seeking comment. Calls to China Minsheng Investment's financing manager went unanswered.

Chinese borrowers began using the SBLCs as a credit sweetener in the offshore market about eight years ago. Issuance of such structure peaked in 2014 and China Minsheng Investment sold its US$300 million note in 2015. The latest sale was from Huaibei City Construction Investment Holding Group Co - a local government financing vehicle - which raised US$150 million bonds at a yield of five per cent this month. Huishang Bank Corp is the SBLC provider.

"Investors should really start to focus on the underlying credits as well as the banks that guarantee them because the borrower can default and it could create systemic risks to the banks," said Raymond Chia, head of credit research for Asia excluding Japan at Schroder Investment Management Ltd.

BLOOMBERG