Photographer: David Paul Morris/Bloomberg
Asian Junk Bond Deluge Spurs Concerns About Debt ProtectionBy and
Covenant quality weakens further to lowest since 2011: Moody’s
Hunt for higher yields drives buyers to lower quality bonds
Asian bond investors may be taking their eyes off the protections on junk bonds in the pursuit of higher yields.
The safeguards provided by the fine print in bond documents have dwindled further, according to Moody’s Investors Service. Its analysis of 10 junk bonds worth $3.34 billion in the last quarter of 2017 showed that covenant strength fell to the lowest level since Moody’s started scoring it in 2011.
As ample cash conditions drive spreads of investment-grade credits to their tightest in more than a decade, investors are turning to lower-rated names which come with added risks. The pace of high-yield offerings has accelerated in 2018 after hitting a record $55.8 billion last year, according to data compiled by Bloomberg.
“Diminishing covenant quality represents risks of company leverage increasing and bondholder ranking being subordinated,” said Charles Macgregor, head of emerging markets at Lucror Analytics Pte. in Singapore. “It reflects poorly on management’s willingness to pay in that they’re not prepared to accept reasonable restrictions.”
The bullish demand for high-yield notes has attracted numerous potential issuers in recent weeks. Chinese developer Yango Group Co. is said to have postponed an offering Monday, which would have been its second sale in three months. The covenant score on Yango’s $250 million of 2020 notes priced in November was worse than the average last quarter, according to Moody’s.
The Ratings Agency Take:
Moody’s is concerned because the decline in protection means companies have more flexibility to move assets out of reach of bondholders and increase investments in risky assets.
- Its analysis shows 22 percent of Asian bonds scored in the weak category for covenants at end-2017, versus 5 percent in 2011, according to Jake Avayou, a senior covenant officer. Strong-to-good protections dropped to 31 percent from 82 percent
- “We are seeing more and more weak covenant packages hitting the market, which tells me investors may be getting complacent,” Hong Kong-based Avayou said
- Asian companies have significant leeway in covenants to make so-called restricted payments, risky investments and incurring extra debt, Avayou said. One stand-out is the proliferation of credit facility carve-outs, which affect the amount of extra debt the issuer can load up on, and are deemed weak because they aren’t tied to a specific purpose
The Investors’ Take:
There’s still strong demand for Asian junk bonds as tightening spreads have increasingly pushed buyers further down the credit curve
- Asian dollar junk bonds returned 3.8 percent in the past six months, compared with just 0.6 percent on investment-grade notes, according to ICE BofAML Indexes. Investors get a spread of 371 basis points over Treasuries on high-yield debt, the slimmest premium since 2007
- The decline in covenant quality is “something that worries me,” said Bhaskar Laxminarayan, chief investment officer in Singapore at Bank Julius Baer & Co. “I would rather worry about the quality and liquidity than buy a set of bonds that are covenant-light”
- “When there is the first sign of trouble,” they defer payments, Laxminarayan said.
The Companies’ Take:
Strong demand for bonds is giving some of the weakest borrowers in the region access to financing. Issuers are testing just how far investors will go in the hunt for yield, with some of last year’s postponed deals being priced successfully.
- Kong Kong-based telecommunications group WTT Investment Ltd. and Anton Oilfield Services Group had the worst scores on account of cash leakage and risky investments, while Indonesian coal producer PT Indika Energy and Chinese builder Times Property Holdings Ltd. also ranked poorly, according to Moody’s
- The ratings company scores six areas of protection to establish covenant quality: cash leakage, investment in risky assets, leveraging, liens subordination, structural subordination and change-of-control clause
- Indika Energy, whose $575 million of 2024 notes sold in November were one of the bonds analyzed by Moody’s, said it “successfully priced” the offering with the lowest coupon and yield across its previous issues since 2007, according to a statement on its website. Its covenant quality score was 2.98, according to Moody’s.
— With assistance by Hannah Dormido