Corporate bonds: The problem with promises

Huarong’s US dollar bond prices fell to distressed levels in April despite the company’s investment grade rating following a combination of events, including the trading suspension of its equity on the Hong Kong Stock Exchange. The delay in the issuance of its annual report and limited official government announcements have been cited as results for this.

Driving these developments were investors’ perception of a reliance on implicit government support for Huarong. This was based on:

• Huarong’s current majority government ownership (China’s Ministry of Finance holds a 61.4% stake in Huarong as at 30 June 2020 while the National Council for Social Security Fund holds 6.3%);
• Huarong’s original policy-driven asset management business that was historically important in reducing non-performing loan balances at the four major state owned banks; and
• The use of keepwell agreements for Huarong’s offshore bonds that do not constitute a guarantee.

While Huarong’s ownership and business may constitute a sound basis for an expectation of implicit external support at a point in time, the concept itself is not so clear cut. This is because these promises exist “between the lines” and are not clearly spelled out meaning that the circumstances surrounding their usefulness can be unclear.

Investors should therefore analyse a variety of factors and circumstances that make such expectations of support based on ‘history’ at best and ‘hypotheticals’ at worst.

Financial capacity

An assumption of implicit support usually starts and ends with the promisor, the entity expected to provide the support.

Logically, the promisor is seen to be stronger as this of course strengthens the “financial capacity” to support — a higher capacity to support provides a buffer for any stress in a promisor’s related entities.

That said, this capacity can evolve over time. In the past, for instance, the capacity of governments to support their related entities or state-owned corporations were high but the pandemic’s significant and wide-reaching impact mean that capacity has become constrained with governments’ need to protect livelihoods.

Put simply, governments have competing interests and no longer have the luxury to support each and every entity.

While financial capacity is the start of any analysis of a promisor, the end is invariably tied to how willing a promise is to settle the debts of the entity it supports. A promisor can have deep pockets but short hands when needed.

Willingness can be influenced by many factors: Financial, strategic, political, as well as philosophical reasons (free market versus socialist tendencies, for example). This makes willingness a somewhat subjective factor, as opposed to the more quantitative factor of capacity.

Being able to combine an assessment of the two factors though can create a more powerful way to analyse the probability of implicit support from the promisor. The combination of high willingness and capacity would be good indicators of implicit support and should be backed by a recognition of a material impact on the promisor should it choose not to support, whether that impact be reputational or financial.

Conversely, a negligible impact from not supporting should signify a low willingness, which is likely enough of an assessment for the probability of implicit support without needing to understand the promisor’s capacity.

Limitations

An analysis of the promisee, or the entity in need of support, is more about relativity. While fundamental analysis remains important in understanding their stand-alone capacity to repay its obligations when due, the more important factor to consider is the strength of a promisor’s relationship with the promisee.

This can more likely be founded on visible factors such as its strategic or financial importance to the promisor. If the promisee is majority owned by the promisor, has board representation (indicating control) or shares the same industry or the same name and branding along with shared support services, then the probability of implicit support will likely be higher for strategic reasons.

Size is also a factor — if the promisee is a significant or material financial contributor to the promisor then the probability of implicit support should also likely be higher for financial reasons. Despite this intuitive understanding that support will be more available for larger sized promisees.

However, size may also have its limitations because if the promisee’s relative size to the promisor is significant then the ability of the promisor to support is ultimately tied to the stand-alone performance of the promisee. This in turn influences the capacity of the promisor. That is, the higher the performance correlation between the two, the lower could be the likelihood of support.

Finally, If the analysis of the promisee shows a very weak stand alone credit profile and a large gap between their fundamental position and that of the promisor’s, then it should call into question the likelihood of support to begin with.

Guarantees

Promises come in many forms and while legally enforceable ones are best, they are also the hardest to come by. This is because of the contingent liability it creates and the crystallisation of the obligation to support. Even then, a legally enforceable promise to guarantee should have certain key characteristics to be effective in transferring credit risk from one entity to another.

For one, it should be timely and ensure the punctual payment of debt when it is due as per the documentation. Secondly, it should be full to ensure that there is no shortfall in the payments promised under the original agreement.

Finally, it should be unconditional. In other words, the enforceability of the guarantee should be unquestionable in its ability to force the guarantor to take the place of the borrower or issuer when the time arises. It should also not create a burden on the lender or investor to prove their ability to enforce the guarantee.

Recently, the challenge of getting guarantees has been met more and more by the growth in keepwell structures, also known as letters of comfort. Keepwell structures sound the same in form as a guarantee in that they can indicate a promisor’s willingness to support a related entity in times of stress, but they are very different in substance.

Such agreements are not legally enforceable and do not give rise to a debt-like liability, therefore falling short of the credit enhancement properties that a guarantee provides. A lender or investor may be able to sue for damages under breach of contract, however any eventual payment for breach of contract will be ultimately conditional on the success of its claim in court. In addition, such payment will not be timely.

Still, keepwell agreements have found favour in the market as a mid-point between a guarantee and implicit support given its tangible nature and its usefulness in allowing Chinese companies to issue offshore bonds without getting the regulatory approval that guarantees require. According to Bloomberg, around 13% or US$119 billion ($159.1 billion) of outstanding Chinese offshore bonds use keepwell deeds, including nearly all of Huarong’s US$22 billion in bonds.

That said, the effectiveness of keepwell agreements was challenged in 2020 when a Beijing court appointed administrator in Peking University Founder Group (PKU Founder)’s court supervised restructuring refused to recognize the claims of bondholders holding US$1.7 billion of bonds made under keepwell agreements. It did, however, recognise claims under corporate guarantees provided by PKU Founder.

While the administrator indicated that these bondholders could object to the court (and some have filed a winding up petition), according to Chinese-Australian law firm King & Wood Mallesons, there is some uncertainty as to the jurisdiction which takes precedence — Chinese courts which accepted the original restructuring application and has jurisdiction over the company; or Hong Kong courts which have jurisdiction to hear any disputes on the enforceability of the keepwell agreement.

While other developments in November 2020 offer some hope with the Shanghai Financial Court recognizing the claims of bondholders under keepwell provisions in the default of CEFC Shanghai International Group, it appears that market confidence in keepwell agreements and implicit government support are on shaky ground judging by pricing action of Huarong’s US dollar bonds since April 1, 2021, when the company suspended trading of its equity.

We expect the market will likely start scrutinising keepwell agreements and Implicit support assumptions more.

The path forward

If Keepwell agreements are on shaky ground, then what about implicit support? It stands to reason that these are on even weaker footing given they sit a rung lower on the ladder of enforceability or promise of payment. But it is not just from a legal perspective that this concept is challenging — after all, lack of legal enforcement is why this concept exists.

The issue in our view stems from the circumstances surrounding the implicit promise to support. It is a promise that is likely made when times are good and when capacity to support may be high and the likelihood to support is low.

If there is no track record, then the support is untested, and the likelihood of support is hypothetical. If there is a track record, then there is only a history of support at best and as all good investment disclosures say, “past performance is no guarantee of future results”.

Invariably, circumstances change which impacts the likelihood of implicit support. The party or individual who made the promise may leave the company. This makes it difficult for a lender or investor to rely on (and unsurprisingly easy for a borrower or issuer or promisor to get out of).

The concept of personnel is even more complex when it comes to implicit government support — while one ministry can indicate support, they may not be the one that ultimately writes the cheque. Some state-owned enterprises may come under the purview of multiple ministries complicating any prospect of support. For example, state owned enterprises in some countries within Southeast Asia can be influenced by the Ministry of Finance, the Ministry for its respective industry and a separate Ministry for State owned enterprises.

There is also the influence of politics when it comes to implicit government support and not just the issue of different political parties within one political system but the ability to predict and rely upon implicit government support between different political systems.

Ultimately, implicit support feels like a short-term promise to pay long-term liabilities — a liquidity mismatch of sorts on its own, with the benefit of any implicit support perhaps cancelled out by an illiquidity premium to compensate for the difficulty of relying on this support when times are tough.

While the situation with Huarong continues to play out, current events highlight the risk of relying on too much implicit support. When that support is not forthcoming or has some delay, it drives higher volatility for the bonds of affected issuers, particularly when the gap in fundamentals between the promisor and the promisee is wide.

This results in a credit cliff scenario. We only consider implicit government or parental support in our analysis on a very limited basis and only when this has been demonstrable through past supportive actions. This is because the concept can be unpredictable as we have explained above. We feel it is of more benefit to analyse an issuer on a stand-alone basis and understand its own fundamental capacity to repay its obligations.

Andrew Wong is a credit research analyst with OCBC