Credit investors flock to Asia despite low compensation

Among other concerns are duration risk and weakening covenants

Asian credit investors have not been compensated enough for the duration risk that they are taking, according to chief executives of private credit managers investing in the region.

Ron Schachter, a co-founder and managing partner at Nine Masts Capital, a Hong Kong-headquartered credit-focused hedge fund, said they are not compensated for maturity risk that they are taking across the region, even in the real estate sector.

We would look to take some of the shorter duration papers,” Schachter noted, adding that the returns from one-year high yield bonds range from a high single digit to 10 percent, on an unlevered basis.

Speaking on a panel, Global Credit Markets: Opportunities in Volatility, at the Milken Institute 2018 Asia Summit held in Singapore last Thursday, he explained that the firm is looking at refinancing opportunities across USD-denominated bonds and Chinese yuan-denominated bonds as borrowers face up to ‘the wall of maturity’ over the next few years.

In fact, among real estate developers in China which issued USD-denominated high-yield corporate bonds, $22.8 billion worth of the debt is set to mature by 2020, according to Dealogic data as of 28 February. Borrowers Kaisa Group Holdings and Evergrande Real Estate Group had over $2 billion of offshore bond issuance based on the aggregate amount of tranche face value.

“Who is going to step in?”  asked Schachter.

DIRECT LENDING & COVENANTS

Direct lenders are spotting the opportunities arising from refinancing demand as investors in the public credit markets are reluctant to take duration risk prior to the large redemptions scheduled by 2020.

Robert Petty, a Hong Kong-based co-founder of Clearwater Funds who is now co-chief executive officer and co-chief investment officer for Fiera Capital Asia, told conference attendees that there is a large opportunity set in Asia, especially on the direct lending side.

“Because you can write your own document set,” he explained.

Clearwater Funds have two vehicles investing in direct lending across the Asia-Pacific region, according to Petty. They are dollar-denominated vehicles and target senior secured loans and residential mortgages.

As Jake Avayou, a Hong Kong-based vice president and senior covenant officer at Moody’s, observed, for high yield bond issuers, there is more flexibility to make restricted payments to pay dividends or for stock buybacks.

He pointed out in the latest report, High Yield Bond Covenants – Asia, published on 10 September, that borrowers, especially Chinese real estate developers, are increasingly pre-dating their income baskets for longer terms without disclosing the accumulated credit in the income basket, which gives borrowers more flexibility to make any restricted payments.

“There’s a threshold for incurring that debt and that threshold, otherwise known as the fixed-charge coverage ratio, is coming down,” said Avayou.

A question is whether investors who are accepting the weaker covenants have been rewarded enough compared to previous credit cycles. For instance, a median coupon rate for high-yield bonds issued by Chinese corporates shown in the Dealogic data was calculated as 8.5 percent as of 28 February.

Borrowers have been able to carve out part of their debt that does not meet the criteria given the weakening covenants seen in the real estate sector across the region.

According to Avayou, debt carve-outs are becoming more common, accounting for 33 percent of total assets compared to 23 percent in 2011.

“What we’ve been seeing in the last two years are higher carve-outs. So, [there are] more exceptions to the test,” he noted, adding that if a company can’t satisfy a ‘debt incurred test’ then they look to the carve-outs, which are exceptions to the test.

As the covenants are the result of negotiations between the issuers and underwriters on the deal, investors tend to buy the tranches when they feel comfortable – unless they can ask for a bigger risk premium or a pushback on the covenants.

According to an industry source who wished not to be identified, his organisation typically seeks returns of up to 12 percent from high yield bonds across the Asia-Pacific region.

Although his organisation has no existing exposure to an Asian private debt strategy yet, he told PDI that their biggest consideration when investing in private debt would be the cash flows.

For credit investors, the danger of having weak covenants is matched by concerns around potential cash leakage from borrowers.

Although Moody’s data shows that Asian high yield full-package bond covenant quality is generally higher than in the US and Europe, Petty noted: “But when you need them, they are not good enough.”