Credit markets are obviously not immune to the malaise and challenges that are inflicting global financial markets. This was illustrated in the Asiadollar market in the middle of September, with higher-than-expected US inflation putting the dampener on Asiadollar issuance, which fell to US$1.19 billion ($1.67 billion), according to Bloomberg, for the week ended Sept 16, down from US$6.14 billion in the prior week.
Of note was not the issuance amount but the issuance types, which were somewhat of a microcosm of recent primary market activity that was skewed to either high-quality government-linked or owned entities, or smaller entities backed by implicit or explicit external credit support. Issuance that week included:
• Korean Air Lines pricing a US$300 million three-year senior unsecured bond at T+90bps, tightening from an initial price talk of T+130bps area. The deal received US$2.8 billion in orders across 197 investor accounts based on the unconditional and irrevocable guarantee provided by Korea Development Bank (KDB), which in turn benefits from government support as reflected in the bank’s status as a 100% government-owned policy bank and as contained in the KDB Act.
• Solar power company Jinko Power Technology pricing a US$100 million three-year senior unsecured green bond at 4.8%. The deal benefited from an SBLC or standby letter of credit from China Merchants Bank, Shanghai branch.
• Guangzhou-based real estate developer KWG Group Holdings issuing US$794.9 million in new notes at 6.0% to mature on Jan 14, 2024, as part of its exchange offer for US$900 million in bonds due Sept 15 and Sept 21 against widespread funding pressure in China’s property sector.
With external credit support recently becoming a frequent occurrence in credit markets, we thought it would be useful to revisit the concept, in particular that of implicit support. The concept itself is not so clear-cut, and investors should consider and analyse a variety of factors and circumstances as expectations of support are usually based on “history” at best and “hypotheticals” at worst.
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The promisor
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 corporates was high. However, the pandemic’s significant and wide-reaching impact along with tightening financing conditions mean that capacity has become constrained. Put simply, governments have competing interests and no longer have the luxury to support each and every entity.
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While financial capacity is the start of any analysis of a promisor, the end is invariably tied to the willingness of a promisor to pay the debt obligation of the supported entity. A promisor can have deep pockets but short hands when needed, meaning that capacity can become a wasted resource.
Willingness can be influenced by many factors — financial, strategic, and possibly political as well as philosophical reasons (i.e., free market versus socialist tendencies). This makes willingness a somewhat qualitative but more important factor that is harder to judge, as opposed to the more quantitative factor of capacity.
Being able to combine an assessment of the two factors can create a more powerful way to analyse the probability of implicit support from the promisor. A high willingness and capacity would be a positive for implicit support and should be backed by a recognition of a material or significant impact (reputational or financial) on the promisor should it choose not to support. Conversely, a negligible impact from not supporting should signify a low willingness, which is likely enough of an assessment for the probability of support without needing to understand the promisor’s capacity.
The promisee
An analysis of the promisee, or the entity in need of support, is more about relativity. While absolute or fundamental analysis remains important in understanding a promisee’s standalone capacity to repay its obligations when due, the more important factor to consider, in our view, from an implicit support perspective is the promisee’s relative positioning to the promisor or the strength of its relationship.
This can more likely be founded on quantitative or 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 but for financial reasons. Despite this intuitive understanding that support will be more available for larger-sized promisees though, 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. That is, the higher the performance correlation between the two, the lower could be the likelihood of support.
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Finally, relativity is also important from an absolute perspective. If the analysis of the promisee shows a very weak standalone credit profile and a very 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.
The promise
Promises come in many forms and while legally enforceable ones are the 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 support or guarantee should have certain key characteristics to be effective in transferring credit risk from one entity to another.
For one, payment of the obligations or amount due should be timely and ensure the punctual payment of debt when it is due as per the documentation.
Secondly, the payment should be in full to ensure that there is no shortfall in the payments promised under the original agreement.
Finally, the payment should be unconditional and not dependent on any other event or circumstance. 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.
In the past, the challenge of getting guarantees was met by the growth in Keepwell structures — also known as Letters of Comfort. Keepwell structures or agreements 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. However, they are very different in substance. Keepwell agreements are not legally enforceable and do not give rise to a debt-like liability, therefore falling very short of the credit enhancement properties that a guarantee provides.
While a lender or investor may be able to sue for damages under breach of contract, 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. While Keepwell agreements found favour in the market for a certain period of time as a mid-point between a guarantee and implicit support, it was recently put to the test (and somewhat failed) following the developments with China Huarong Asset Management in 1H2021 that highlighted the pitfalls of over-relying on implicit external support or a “promise” to repay.
The problem
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, this concept exists due to lack of legal enforcement.
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, when capacity to support may be high and the likelihood of requiring 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 read: “Past performance is no guarantee of future results.”
Invariably, circumstances change which impacts the likelihood of implicit support. Personnel changes too, so the person or party who made the promise may no longer be there. This makes it difficult for a lender or investor to rely on (and unsurprisingly, easy for a borrower/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 the same 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.
OCBC Credit Research only considers 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, Ezien Hoo and Wong Hong Wei are credit analysts with OCBC
