Covenant packages for Asian high-yield bonds were much stricter in the second quarter than the first, expanding the disparity over similarly rated US, Latin America and European notes — an indication that investors are still cautious about the securities.
For starters, Asia is plagued by structural issues. This problem is more noticeable in countries like China, where foreign investors are buying bonds from an empty shell that, in turn, owns a stake in the operating company in China; they have no direct security over the underlying assets.
Since the offshore bonds are not counted as debt on the balance sheet of the mainland company, foreign bondholders are subordinated to onshore credit — meaning they are unlikely to recover much cash if the company goes bust.
Secondly, Asia is marred by legal uncertainty. In the US and Europe, market players have more certainty with the legal structures in a bankruptcy scenario whereas in Asia, it’s more ambiguous or more accurately put, untested, which adds an additional risk.
This has prompted the region’s high-yield experts, bankers and lawyers alike, to tackle covenant packages — a legally binding term of an agreement between an bond issuer and bondholder — on a borrower case-by-case basis in different jurisdictions in order to safeguard the wellbeing of investors in general.
“In Asia, you are always working in subsets. Asia has a lot more challenging jurisdictions in terms of structural challenges…for example, in China, you can’t get onshore guarantees easily,” a Hong Kong-based lawyer told FinanceAsia, although China’s State Administration of Foreign Exchange recently relaxed rules around such safeguards.
Guarantees are essentially contracts between the parent company and its subsidiary to maintain solvency and financial backing throughout the terms set in agreement, thereby giving bondholders additional reassurance. This typically involves an offshore group company issuing debt, with credit support provided by the onshore group or third-party.
“Also, in places like the US and Europe, there’s an enormous precedent of how companies go through bankruptcy and how the debtors are dealt with,” added the lawyer. “That in some ways may lead to people having different opinions on the flexibility of covenants used in the West versus Asia, which is still untested.”
Bond covenants are designed to protect the interest of both issuers and investors. Negative or restrictive covenants forbid the borrower from undertaking certain corporate activities while positive or affirmative covenants require the issuer to meet specific requirements.
Some of the more popular covenants used in high-yield bonds include “change of control” covenants, as well as limitations on various areas, including indebtedness, restricted payments (which include dividends, distributions, and investments in minority shares), asset sales, affiliate transactions, mergers, and restrictions on distributions from subsidiaries.
According to a recent Moody’s report, from a score of one to five (one being the strongest and five the weakest), the average covenant quality score for Asian rated deals launched since 2011 is 2.48, much stronger than the global average of 3.33.
Although the covenant quality for Asian issuers has been modestly declining since early 2011, the average scores for deals launched in the second quarter of this year strengthened from 2.67 from 2.82 seen in the first quarter, the rating agency added.
“Twelve deals closed in the second quarter, four of which were for non-Chinese issuers,” Laura Acres, associate managing director at Moody’s said in the report released July 15. “Non-Chinese deals tend to have stronger scores, which contributes to the stronger second quarter score.”
Approach cautiously
While stricter covenants are viewed positively by the market, this is also an indication that investors have been approaching Asian high-yield bond deals with extra caution.
This is due to the fact that the region’s high-yield sector possesses large concentration risk as it is heavily dominated by borrowers from the Chinese properties space — a highly volatile sector that has unfortunately been tainted by a few negative headlines.
In fact, China faces what would be the second default in the nation’s onshore bond market after Huatong Road & Bridge said in a statement to the Shanghai Clearing House on July 15 that it may miss a Rmb400 million ($64.5 million) note payment due July 23, the latest sign of financial stress in the world’s second largest economy.
Based in the northern province of Shanxi, the company’s business include bridge and highway construction, real estate, coal, eco-friendly construction materials and agriculture-related projects, according to its website.
This follows March implosion of closely held developer Zhejiang Xingrun Real Estate also fueled concern that defaults could spread, particularly among companies connected to the cooling of China’s property market.
As a result, syndicate bankers view the lack of issuer diversification in the high-yield space is a hindrance to the advancement of covenant packages in Asia.
“The much larger and more mature high-yield markets in the US and Europe have been extremely active over the past several years, and over time, given way to a gradual relaxation of covenants in terms of what issuers are able to push the boundaries,” Luke Garner, co-head of high-yield capital markets, Asia ex-Japan at JPMorgan said to FinanceAsia.
“In Asia it has been a bit slower in terms of covenant evolution. This is because in Asia we are dealing with a much more volatile and still developing market backdrop,” he added. “The periodic volatility in the Asian bond market has been largely driven by macro headlines such as China’s real estate sector — which is the biggest driver of Asia high-yield.”
Dollar-denominated high-yield bond issuance in Asia ex-Japan has touched $14.8 billion year-to-date, with the Chinese real estate sector accounting for more than half of that total, according to Dealogic data.
Shanghai Chaori Solar Energy Science & Technology marked China’s first onshore corporate bond default in March when it missed a coupon payment.
Despite these concerns, market participants are aware that the region’s high-yield market is still relatively young compared to the US and Europe, and would take some time before it will see an overall continued theme of covenant relaxation.
“If the market continues to improve and mature, I expect to see a gradual relaxation over time or additional flexibility layered into these covenant packages, especially for existing issuers that have proven themselves to investors over the last few years,” Garner said.
