The bankruptcy of Peking University Founder Group (PUFG; unrated) earlier this year has thrown up a surprise test for keepwell deed structures for Chinese offshore bonds. In sorting through the claims, PUFG's state-appointed administrator has included offshore bonds directly guaranteed by the China state-owned conglomerate. The administrator has not, however, recognized the offshore bonds backed by keepwell deeds.

So while guaranteed offshore bondholders can participate in the restructuring process, with the hope of getting some return on their investment, the claims from the keepwell-deed bonds are still pending. The liquidators have requested additional documentation and S&P Global Ratings believes a decision on their legality could take several months. If they decide against the keepwell claims, this could have negative implications for the outstanding keepwell bonds.

Keepwells and equity interest purchase undertakings (EIPUs) are popular structures for China's offshore bonds. They have been used since 2012, often in cases where the onshore parent company has taken a quicker path to tap funding in the offshore market, without obtaining quota or approval necessary to provide a guarantee to the offshore issuing vehicle.

While we do not rate PUFG and its offshore subsidiaries, in our view, the PUFG case highlights both the structural-subordination and regulatory risks for offshore bonds with keepwell deeds, EIPU and similar provisions.

We note that the market doesn't seem to differentiate between issuances that use a keepwell structure instead of a guarantee from the onshore parent. If the PUFG keepwell claims are not recognized amid the recovery process, market attitudes could change.

Frequently Asked Questions

What's the difference between a keepwell deed and a guarantee in the Chinese context?

A keepwell deed is a statement of commitment made by the onshore parent company in support of the offshore issuer. Under most keepwells, the parent undertakes to ensure the issuing subsidiary remains solvent and has sufficient liquidity to service the interest and repay the principal of the bonds. Typically, additional documents--such as an EIPU and liquidity facility support agreements--outline the measures that the parent could take to help its subsidiary. The validity and enforcement of the keepwell structure has not been tested in mainland China until now, with the PUFG case.

Bonds under a direct guarantee structure have unconditional and irrevocable payment guarantees by the onshore parent, and their enforceability provides better protection for noteholders than a keepwell. In China, the registered guarantee has received the approval from the State Administration of Foreign Exchange (SAFE). The exercise of the guarantee obligation is less likely to be subject to any cross-border foreign-exchange controls, especially currency conversion and payment issues. We believe the guarantee structure provides more protection to noteholders with stronger credit strength than under a keepwell deed. This has been our longstanding view.

Is there a difference in bond ratings for keepwell versus guaranteed issuances?

Yes. S&P Global Ratings rates such keepwell transactions by assigning an issuer credit rating to the offshore issuing subsidiary. To this end, we assess the strategic role of the offshore issuer as the financing platform to the parent and the potential parental support. The rating on the offshore entity and the bond rating are usually below the rating on the onshore parent except in very limited cases--where the offshore is a core part of the group and is fully integral to the group's primary business or makes a significant contribution to the parent, among other factors (see "Group Rating Methodology," published on RatingsDirect on July 1, 2019). Nearly all Chinese offshore issuers with keepwell bonds that we rate are one notch lower than the rating on the onshore parent, which provides the keepwell.

In contrast, guarantees are direct legal obligations of the guarantor. We would typically equalize the guaranteed debt rating with the senior unsecured issue ratings on its guarantor if the criteria elements are satisfied. Guarantees of payments are irrevocable and unconditional obligations of the guarantor.

Would a bad result in the PUGF case lead to a lowering of issue-level ratings on Chinese offshore bonds with keepwells or other credit enhancements in lieu of guarantees?

Probably not. We do not treat keepwell as guarantees. So, our ratings already reflect the structural subordination for offshore bonds that are not guaranteed by the onshore parents.

If we were to review any ratings, we would do so to assess if the parent company's commitment to the offshore issuing entity has changed as a result of the court judgment. Any action in the sector will be on a case-by-case basis, determined by the creditworthiness of the individual parent groups, and offshore issuers' importance to the group as part of the rating process.

Offshore issuers play an important role in securing foreign currency funding for many Chinese companies. Nearly all of these offshore issuers are the sole offshore funding platform for their onshore parent group. We believe the incentives for the parent company to support their offshore vehicles remain strong for this reason.

Table 1

What proportion of China offshore bonds go the keepwell route, and how do we expect the market to treat these structures?

We estimate bonds with keepwell provisions account for nearly 15% of outstanding Chinese offshore dollar bonds (including financial institution and corporate issuers). Many Chinese companies employ this type of structure, including property developers and local government financing vehicles (LGFV).

Chinese issuers have commonly used keepwell structures since 2012 to circumvent regulations that did not allow them to use offshore bond proceeds onshore. They might repatriate back to the mainland the proceeds of keepwell bonds in the means of equity capital or shareholder loans of offshore issuers or others. However, policy developments are increasingly supportive of direct issuance by Chinese issuers. In 2017, the central bank and SAFE also further relaxed policies to allow the return of bond issuance proceeds directly issued or guaranteed by Chinese companies back to the mainland.

Keepwell-type agreements are already on the decline. For example, in 2017, issuance with keepwell provisions reached US$28.7 billion, or 14% of total offshore dollar-bond issuance for that year. By 2019, this dropped to US$15 billion, or nearly 7% of the total. This compares to US$61 billion in 2019 issuances that are guaranteed by the parent--roughly 27% of total offshore issuance last year.

We expect the keepwell bond market to continue to shrink in the next several years, although some companies may still use keepwell provisions as this structure gives them flexibility without registering with SAFE.

If PUFG's keepwell bonds are rejected by the Chinese bankruptcy administrator, market pricing may embed deeper structural subordination on top of expected default risk, demanding higher risk premium. As a result, higher funding costs could reduce the supply of keepwell bonds. That would be a positive development for the capital market as it may result in more transparent bond structures, such as direct issuances or guaranteed bonds, become the standard.

Related Research

• Group Rating Methodology, July 1, 2019
• Offshore And Offguard: How Forex Risks Caught Out Tianjin Binhai, June 6, 2017