The Hong Kong-based senior covenant officer at Moody’s Investors Service says a trend of developers chipping away at debt protection and investors accepting it is “dangerous.”
Chinese covenant packages are getting diluted in some of the $28.5bn of high-yield deals this year.
Aviva Investors is concerned about complacency while Schroder Investment Management Ltd said investors will rue weak safeguards when companies go under.
“I’ve never gotten as many questions from investors as I have in the last few months,” Avayou said in an interview on September 4. “They have become more selective of deals and they are doing more rigorous analysis of covenant packages.”
While covenant quality across Asian high-yield bonds improved last quarter, Chinese developers saw this metric weaken compared with the long-term average seen between 2011 and this year, according to Moody’s assessment. Chinese borrowers are going against the grain by capitalising on the voracious appetite among investors as yield quest persists.
The fixed-charge coverage ratio, which measures a firm’s ability to meet its expenses with income, has weakened over the past three years, while more leeway for cash leakage, that allows executives to move company assets out of the reach of bondholders, is built into newer covenants.
Sunac China Holdings in August eased a provision that increased the risk of cash leakage into its non-core business. Agile Group Holdings and LVGEM China Real Estate Investment Co introduced a provision on bonds sold last month that allows it to take on more debt with no conditions on the use of proceeds, which Avayou said was a new feature seen among bonds in the region.
Both Agile and LVGEM declined to comment. Sunac’s investor relations department didn’t reply to an email seeking comment.
“The ‘standard market practice’ pitch from bankers is causing a vicious cycle, making more companies want to weaken their bond covenants,” said Raymond Chia, Singapore-based head of credit research for Asia ex-Japan at Schroder Investment. “This is detrimental to bond investors. Covenants are the last line of protection. Investors will only know its value when a company goes down.”
Developers accounted for 72% of the $28.5bn of Chinese junk-rated bond sales this year, according to data compiled by Bloomberg.
That’s up from 45% of $16.5bn raised in all of last year. Even so, investors can’t get enough of these securities as orders have continued to strengthen this quarter.
Sales and cash flows are pretty strong and their inventory levels have been improving, according to Ken Hu, chief investment officer for Asia-Pacific fixed income at Invesco Hong Kong.
Some investors are willing to buy these bonds partly because many Chinese developers are repeat issuers, offering the comfort of familiarity, according to Sean Chang, head of Asian debt investment at Baring Asset Management (Asia).
“For bonds of three-year tenors and above, investors should be more demanding on the protections,” he said. “There is less certainty on the companies’ operations many years out.” The average maturity of Chinese high-yield property bonds issued in 2017 has lengthened to 4.3 years compared with 4 years in 2015, according to data compiled by Bloomberg.
“We are in an environment where companies can issue at tight spreads and investors will also accept weaker covenants because of the sheer weight of demand,” said Jethro Goodchild, Singapore-based head of Asian credit at Aviva Investors. “Investors are getting complacent and that does concern me.”
Recent distressed situations in the broader Asian junk bond market - such as Noble Group and a spate of defaults in Singapore’s bond market - have highlighted such risks and shortcomings. Examples include covenant breaches at Shanghai- based Greenland Holdings Corp and Hong Kong-based Hsin Chong Group Holdings.
“Whenever investors are chasing yields, they are willing to look past weakening covenants,” Avayou said. “The more-seasoned issuers are taking advantage of that and have loosened their covenants and investors have accepted it. I think it’s dangerous for investors.”