Asia covenant quality drops to its lowest level ever – report

The trend of deteriorating covenants looms over lenders’ risk protections, yet Asia still ranks top in covenant quality globally.

Covenant quality in Asia showed a record weakening during the fourth quarter of 2019 amid the lowest-ever quarterly issuance level for rated high-yield debt, according to Moody’s research released last week.

Moody’s reported that there were 19 issuers of what it rates as high-yield bonds during the quarter. Of these, 12 repeat issuers contributed significantly to the loosened lender protections. The weakest covenant quality score for a single issuance was for Kaisa Group Holdings, a Chinese property developer.

The research also pointed out an increase in the proportion of high-yield-lite deals across the Q4 issuances. According to Jake Avayou, a Singapore-based vice-president and senior covenant officer at Moody’s, a high-yield-lite deal is a bond that is missing either a restricted payments covenant or a debt incurrence covenant, or both.

Wanda Properties Overseas, another Chinese property developer, issued its first high-yield-lite bond. In Q3, the agency tracked a total of five high-yield-lite bonds.

Among key covenants the rating agency assessed, the cash leakage scores of full-package bonds – issuances with two main covenants, such as a minimum restricted payments covenant and a debt incurrence covenant – weakened by 24 percent compared with Q3.

Avayou said restricted payments covenants are designed to protect bondholders from the company paying dividends to equity holders or buying back shares from them.

“As a bondholder, you want to have protections in place so that the borrower can service the bond and ensure that the company can have enough cash [to do so],” he told Private Debt Investor.

Covenants and defaults

Similarly, covenant quality is a key consideration to private lenders looking to mitigate risks associated with loans.

The Alternative Investment Management Association, a London-based industry body, noted in its latest report on private credit, Financing the Economy, that less stringent loan covenants do not always reflect less robust lending practices. However, it added that more relaxed loan covenants were dampening expectations of how private credit may perform in a downturn.

Mark Jenkins, a managing director and head of global credit at The Carlyle Group, said in the report: “The rise of covenant-lite loans will certainly decrease the probability of default over the cycle. The only way you are going to default is if you have a payment default. The severity of those defaults, of the actual recoveries, however, could be much worse.”

Christopher Mikosh, a Hong Kong-based portfolio manager and co-founder of Tor Investment Management, told PDI he had not seen any impact on covenant quality in his team’s private credit transactions, despite the generally weak covenant quality in the Asian high-yield bond market.

He said that while in the European or US private credit mindset the dividing line tends to be between covenant and covenant-lite, in Asia-Pacific it is between well-structured senior or operating company debt and more equity-like debt structures. The majority of Asian high-yield debt, he added, is holding company issuance or special-purpose vehicle issuance.

He said this is not suitable for Tor’s Asia credit strategy due to structural and governance concerns: “Covenant-lite loans are not a theme in our private credit transactions as we see more corporates seeking private lending as a means of financing.”

Asia scores top

The Emerging Markets Private Equity Association’s latest report about private credit in emerging markets, released in May 2019, quoted industry sources as saying that private credit covenant quality was stronger in Asia than in the US and Western Europe, where covenant-lite debt deals had gained popularity.

It said covenant-lite deals are borrower-friendly structures that offer less security and protections for the lender.

In 2018, the volume of covenant-lite loans as a percentage of total transactions reached 88 percent in Western Europe – up from zero seven years previously. The report, citing data from S&P Global Market Intelligence, also stated that 80 percent of newly issued first-lien loans in the US were rated as covenant-lite, compared with only five percent in 2010.

The scope of the EMPEA report included emerging Asian markets such as those in South-East Asia, China and India.

Moody’s observed a similar trend in Asian high-yield debt covenant quality. The agency’s report noted that despite the weak covenant quality seen during Q4, the Asian covenant quality score was much stronger than the global average and the averages for the Americas, Europe, the Middle East and Africa.