More Chinese banks are issuing perpetual bonds as a way to replenish capital and support their loan growth, with regulatory incentives spurring 569.6 billion yuan (US$79.6 billion) in total issuance last year for one of the riskiest types of bank debt.
But with more unlisted city and rural lenders also issuing perpetual bonds this year, analysts say investors are facing higher risk issuers with weaker governance. Issuance in China last year already exceeded all perpetual bonds issued by European banks in the three years of 2016-18 combined, at EUR70.59 (US$77.92 billion), according to data from S&P Global Market Intelligence.
Perpetual bonds are equity-like debt instruments whose investors are first to be hit if banks run into serious trouble. They are considered risky debt because investors can see their principal wiped out if regulators deem the bank non-viable.
The potential riskiness of the trend was put into focus last week, when Bank of Huzhou issued a 1.2 billion yuan perpetual bond at a 4.7 per cent coupon. The unlisted bank is the smallest bank in Zhejiang province, with 52 billion yuan in assets. But prior to its bond issuance, the Chinese banking regulator and foreign exchange control regulator had fined the bank for fund misappropriation and failing certain reporting obligations, raising questions about the bank’s governance.
Chinese banks started issuing yuan-denominated perpetual bonds last year after Bank of China’s inaugural 40 billion yuan issue in January.
Banks like issuing perpetual bonds because of a tax break, said Geoffrey Choi, Asia-Pacific financial services assurance leader at EY. The tax deduction is not available to issuers of preference shares, which are similar to debt with a fixed dividend payout. Both instruments are classified as “additional tier one capital” (AT1), which is a type of non-equity capital that banks must hold for regulatory compliance.
“Most of the banks that had issued preference shares in the past have now switched to issuing perpetual bonds as the funding cost is lower after the tax deduction,” said Choi, adding that issuers could also benefit from faster approval and quicker issuance compared to preference shares.
This year, a total of 274 billion yuan perpetual bonds has been issued – more than five times higher than at a same point a year ago, according to data from the mainland media.
Apart from Bank of Huzhou, other smaller city and rural commercial banks have also issued perpetual bonds. These include Guilin Bank in Guangxi province, Huarong Xiangjiang Bank in Hunan province, which are unlisted and would not qualify to issue preference shares.
The surge in perpetual bond issuance comes as the coronavirus has grounded China’s economic growth, with first quarter GDP contracting 6.8 per cent. To support the struggling economy, Chinese regulators have been encouraging banks to issue more perpetual bonds to shore up their capital to backstop their loan growth.
Significantly, for unlisted, smaller banks which typically lack easy access to capital markets, perpetual bonds are an alternative way to raise funds, said Grace Wu, head of Greater China Bank Ratings at Fitch Ratings.
But the flip side is that investors are also facing issuers with a higher risk profile.
“Unlisted banks generally have weaker franchises as well as capitalisation due to their lower profitability or faster growth compared to listed peers. Additionally, strong local government influence, or related-party lending at city and rural banks may raise governance issues,” said Wu, adding that their narrower geographical focus also increases concentration risks.
Concerns about Chinese smaller banks’ viability was highlighted last year when the central bank and regulator seized control of unlisted Baoshang Bank, an Inner Mongolia-based lender, for a year after the bank collapsed following fund misappropriation by its controlling shareholder.
Banking regulators invented “AT1” instruments such as perpetual bonds after the 2008 financial crisis as a way to impose principal losses on creditors when banks go into financial distress, rather than resorting to taxpayers’ money to bail out a failing bank.
As a result, these instruments are often structured with triggers tied to a bank’s viability which, if hit, could lead to the bond being written off so that the bank’s debt load can be reduced.
These bonds are called “perpetual” because, while the bank has the discretion to early repay the bond, typically on the fifth year of its tenor, it could also choose not to do so.
In China, banks’ asset management arms and insurance companies are investors in perpetual bonds, said Dennis Wong, head of markets for North Asia at ANZ, and “most domestic investors regard perpetual bond as a five-year bond”.
Outside China, Deutsche Bank became the first leading European bank this year to not take the step of repaying early its “AT1” bond raised in 2014. Chinese banks will have until 2024 to make that call.
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