SINGAPORE, Jan 30 — Asian bond investors may be taking their eyes off the protections on junk bonds in the pursuit of higher yields.
The quality of covenants, which are clauses in bond documents that restrict issuers from certain activities that weaken their ability to repay debt, has deteriorated further, according to Moody’s Investors Service. Its analysis of 10 junk bonds worth US$3.34 billion (RM12.94 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 US$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 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 per cent of Asian bonds scored in the weak category for covenants at end-2017, versus 5 per cent in 2011, according to Jake Avayou, a senior covenant officer. Strong-to-good protections dropped to 31 per cent from 82 per cent.
“We are seeing more and more weak covenant packages hitting the market, which tells me investors may be getting complacent as far as covenants are concerned,” 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 per cent in the past six months, compared with just 0.6 per cent 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 US$575 million of 2024 notes sold in November were one of the bonds analysed 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. — Bloomberg