Earlier this month, US fund manager Fidelity took the somewhat unusual step of organising a lunch briefing at its office in Hong Kong to educate the media on bond covenants. The fund manager was irked by covenant changes made by Asian high-yield borrowers recently and wanted to drum up support for its cause.
“We need the help of you in the media, the help of rating agencies,” said Sabita Prakash, head of Asian fixed income at Fidelity Worldwide Investment. “In Europe, these things don’t happen. That’s because investors don’t accept it when there are covenant changes. Here, we need to educate investors that not all changes are what they seem — humdrum and superficial. They can be fairly big, fairly significant and investors are not getting compensated.”
At the heart of the matter are bond covenants, which are legally binding obligations set out in a bond issue, typically a high-yield bond, to protect investors. The standard covenants protect investors in the event of a change of control, limit a company’s ability to incur more debt, restrict cash leakage to other group companies and so on.
Fidelity claims that investors in Asia are getting insufficient compensation in exchange for substantial changes to covenant packages. And it is advocating that investors stick to their guns and keep those agreements in place.
“Just like with your home loan or car loan, you wouldn’t just go to the bank and demand for those terms and conditions to be changed,” said Bryan Collins, a portfolio manager at Fidelity. “The same for bonds. Bondholders are the ones who should determine if those conditions are changed and not the other way around.”
Asia’s high-yield bond market is valued at about $100 billion. It is a growing market but it is also one that is less coordinated and mature than the US and Europe. Additionally, the investor base in Asia is fragmented and the bonds are often held by a disperse group of investors, including private banks, fund managers and institutions.
This makes it difficult for shareholders to act collectively. Covenant changes usually require a simple majority to be passed, and investors sometimes vote in favour of these changes for fear of losing the incentive fee if they don’t.
What is worrying to the fund manager is that the level of covenant changes has become “much more egregious”. During the briefing, without naming names, Fidelity cited one company that had proposed an “excessive” removal of debt incurrence tests, lowered the fixed charge coverage ratio substantially and changed clauses allowing them to invest more aggressively. All in exchange for just 75bp in consent fees.
It isn’t clear to what extent some covenants are being loosened because the bonds are held by “friends and family” of the company who are voting in favour. But, by and large, the reason for covenants being loosened appears to be less nefarious — ie, simply because investors are not organised enough.
“If the covenant changes are biased towards an equity holder and you’ve got equity holders potentially owning the bonds, then they might be inclined to accept if it’s for the benefit of them from the equity perspective,” said Collins.
“Some get through because of aligned interest. But the vast majority of covenant changes go through because you have a diversified group of bondholders that may not be as coordinated, who are looking for a short-term gain and may not understand and appreciate what the longer term implications are.”
Debt bankers — who work with companies on consent solicitations to loosen covenants — point out that companies need financial flexibility and that investors could also be more actively involved in the structuring of a bond.
“Yes, Asia’s high-yield market is less coordinated,” said one debt capital markets banker. “But if investors want a greater say, they can dictate the terms if they take a bigger position and say what terms and structures they want. They can do this via a reverse enquiry. We don’t see enough of that.”
