Silk Road bonds could be an innovative capital market solution with the potential to benefit a vast number of people in Belt and Road countries, many of which have been previously ignored by the international bond market.
Their development will help spur the economy not only of China, but also other countries along Belt and Road routes, a win-win for global trade and for poverty reduction.
At the same time, there is a need for third-party verification for this new asset class and perhaps an external support mechanism to ensure investors can assess the risk versus return trade-off.
Silk Road bonds could offer investors both portfolio diversification into other Belt and Road countries, and extra yield in exchange for lower liquidity and longer tenor.
However, first and foremost, the concept needs to be clarified by the investment communities and governments of the Belt and Road countries, especially China. As yet, there is no single concept for Silk Road bonds.
In our view, Silk Road bonds could come with an additional support mechanism and, in order to ensure the mechanism is in place, a definite concept that everyone agrees on is badly needed.
The concept should not be too rigid, so as to allow for flexibility in structuring the new bonds, but it needs to be sufficiently clear to prevent exploitation of the additional support mechanism.
Silk Road bonds could offer investors portfolio diversification into other Belt and Road countries
In general, the Silk Road bond concept should entail the use of proceeds to fund infrastructure projects along the Belt and Road routes.
Silk Road projects will need to be defined, and proposers should also indicate the anticipated benefits to Belt and Road countries. In that sense, a ratio of economic benefits to the country where the project is situated to economic benefits to other Belt and Road countries could be a good indicator of overall value.
Dagong is a member of a working group, organised by the International Capital Market Association, working with many market participants to establish a Silk Road bond concept.
Proposed Silk Road routes take in many different territories and, as a result, there are two key credit considerations. First, given the diverse territories, there could well be multiple levels of risk, all of which will form the operating environment for Silk Road bond issuers.
Since infrastructure projects will likely be supported by central governments, a lack of country knowledge and the complexity involved in evaluating multiple countries could prevent credit analysts from assessing the level of external support those projects might receive.
Another issue is how well the investor community will be able to gauge the level of mutual support of countries along the Belt and Road routes. Simply speaking, a failure to pay in one country could affect subsequent projects in other countries along the routes, so the existence of mutual support will be critical.
Second, investors may lack knowledge of some of the countries along the routes and, in fact, these countries are likely to be the ones that most need new infrastructure in the first place.
Many Belt and Road countries are not very well known to investors and the majority of the Belt and Road countries are classified as high risk by the investment community.
Despite the fact that only two out of 65 countries along the Belt and Road routes are not rated by any major international rating agencies (Iran and Turkmenistan), many countries do not have a presence in the international bond market.
The median and average GDP per capita of Belt and Road countries were $5,496 and $10,402, respectively, according to the latest information from the World Bank, both low compared with those of many developed countries.
Potentially, Silk Road bonds could be secured with assets such as infrastructure projects. To properly gauge the credit risk of secured bonds, credit analysts will need to understand the recovery rate of these assets. The subsequent issue would be whether a project will be a brownfield or greenfield project.
For a brownfield project or a project in operations that already generate cash flow, investors may not have a reliable default history, recovery information or tested bankruptcy procedures in many of the Belt and Road countries.
For a greenfield project, or a project either under construction or a project that has not started construction at all, project finance will require experts to look into a project’s future cash flow. We believe independent third parties (ie credit rating agencies) could come in to study underlying assets so that investors can properly assess the recovery rate of the bonds.
We believe one of the solutions for difficulties in assessing multiple countries of risk and unfamiliar underlying assets is a credit enhancement, ie a guarantee or a wrap, either from a government or commercial banks (in the form of standby letters of credit).
Silk Road bonds’ tenor could be long, ie 10 years or more, as Silk Road bond proceeds could be used to fund long-term infrastructure projects. A longer tenor makes external support in terms of guarantees by multilateral organisations problematic, in our view.
Silk Road bonds can be listed in multiple countries and under different regulatory regimes, especially multiple Belt and Road countries. Every Silk Road bond could carry different disclosures, accounting standards, laws and languages.
In addition, investors may not have access to some markets, which will make some Silk Road bonds less liquid.
Different accounting standards mean foreign companies could be discouraged from issuing Silk Road bonds in a country where they need to convert their accounting standards (as in the case of Panda Silk Road bonds, where issuers would need to provide financial statements according to Chinese Accounting Standards).
We believe many Silk Road bonds will come with extra features, such as sustainability (ie Green bonds) and/or Sharia compliance (ie Sukuk bonds). These features are compatible and can overlap.
So there could be Green Silk Road bonds, Sukuk Silk Road bonds or even Green Sukuk Silk Road bonds.
The Chinese government is committed to the growth of the Green bond market. Likewise, the new Silk Road covers many Islamic countries and we would not be surprised to see Sukuk Silk Road bonds marketed to Islamic investors.
We believe all of the above unique features could necessitate Silk Road bond certification by third parties. In fact, third-party verification may be needed from the outset to certify whether Silk Road bond proceeds are genuinely to be used to fund Belt and Road countries, and whether a project is qualified as a Belt and Road project.
Finally, investors will need to be able to differentiate credit quality among Silk Road bonds. In general, investors carry out credit due diligence through credit ratings and credit research. The former relies on local and international rating agencies, while the latter relies on in-house credit teams, asset managers and/or sell-side research houses.
We believe that we need sufficient rating coverage for Silk Road bonds, as dedicated in-house research could take time to be built up. However, we expect the availability of research and ratings on Silk Road bonds to grow in tandem with the rising demand and supply of Silk Road bonds.
In conclusion, we believe Silk Road bonds are here to stay, but there are a few loose ends that major governments along the Belt and Road routes, together with the investment community, must work on together.
A simple form of government-guaranteed project bonds, of which proceeds will be used to invest along the Belt and Road routes – could be a useful first step to draw more investor attention. We believe that there is liquidity waiting to be deployed and that investors are ready for this new asset class.
Warut Promboon is chief rating officer at Dagong Global Credit Rating Ltd in Hong Kong.
This article was taken from the November 2016 issue of The Treasurer magazine. For more great insights, log in to view the full issue or sign up for eAffiliate membership
