Why bond covenants matter

Investors of China Huarong Asset Management’s (Huarong) offshore bonds were shaken in early April this year. Bond prices fell by nearly half due to the delay of the publication of Huarong’s annual report and a trading suspension imposed on April 1.

Yet, there was no such panic when it came to Huarong’s onshore bond prices, which held up relatively well.

The contrasting responses boil down to the difference in structure. Although onshore bonds are directly guaranteed by Huarong, the same cannot be said for their offshore bonds, for which Huarong merely gives a gentlemen’s agreement but not a guarantee.

In other words, offshore bondholders may not have a direct claim on Huarong’s assets should the company have to restructure.

A bond’s riskiness is not only dependent on the credit quality of the issuer, but also the promises that come attached with the bond. The Huarong incident demonstrates why a company’s ability to repay is only one side of the equation; enforceability of claims or payment is another issue

Other issues to watch out for include promises to prioritise payments to bondholders over shareholders, not to over leverage, not to dispose or strip important assets from the company and not to change controlling shareholders.

We will discuss several covenants which bondholders should pay attention to.

Promise to remain as a Temasek-linked company

Investors tend to accord a “Temasek premium” for Temasek-linked companies (TLCs), which are companies owned in whole or in part by sovereign wealth fund Temasek Holdings.

As such, it is important to assess if the company will continue to be Temasek-linked after any change. Bonds issued by TLCs tend to trade at lower yields as investors deem such companies to be safer.

This is not entirely irrational as TLCs tend to enjoy better access to financing. In addition, Temasek has on several occasions injected capital in times of need (like Singapore Airlines during the Covid-19 crisis, Olam International, Sembcorp Industries for example) which helped to stabilise these TLCs’ credit profiles.

If there is uncertainty over whether Temasek would remain a shareholder, investors should assess whether there is adequate compensation should Temasek divest its stake.

In 2016, Neptune Orient Lines (NOL) saw its NOLSP 4.65% ‘20s bond fall by around 30% when Temasek announced it was divesting its majority stake of 67%. This is not surprising as NOL had lost its halo as an infallible company — without Temasek’s perceived support, investors were worried about NOL as a loss-making, indebted company being subject to the market cycles and steep competition of the shipping industry

Another NOL bond —NOLSP 4.4% ‘19s — which featured a 150 basis point step-up upon a change of controlling shareholder saw prices fall by around 20%.

Clearly, the step-up was insufficient, though some compensation is better than none.

Promise not to strip important businesses or assets from the company

Assuming no new financing, repayment is usually supported through cash flows from operating businesses or divestment of assets. When businesses or assets are stripped from the company, the ability to repay bondholders is generally weakened.

In a recent example, CapitaLand announced a restructuring move which included spinning out around 48% of subsidiary CapitaLand Investment Management (CLIM).

While CapitaLand shareholders cheered with the share price opening higher on the announcement, CapitaLand bonds and perpetuals traded down. To CapitaLand bondholders, they gained nothing in return from the restructuring exercise while almost half of CLIM would be lost to the CapitaLand group.

CLIM is important to CapitaLand bondholders as it generates recurring income for the group and holds the majority of CapitaLand’s assets. Without promises not to strip away important businesses or assets, there is little recourse for CapitaLand bondholders.

We are currently reviewing CapitaLand’s Neutral (3) Issuer Profile Rating for a downgrade given the expected weakening in the company’s credit profile once the restructuring exercise completes. Stripping away important assets is not uncommon for shareholders pursuing value-maximisation, which may conflict with the interest of bondholders.

Although promises can confer some degree of protection, it is difficult to cover bondholders from all angles. For example, Fraser and Neave (F&N) in 2013 announced a spinoff of its property arm Frasers Centrepoint (FCL, now renamed as Frasers Property).

As bondholders were promised that principal subsidiaries will not be spun off, F&N sought bondholder’s consent to tender the bonds. However, for two bond tranches, the tender price was below the market deemed this unfair given the potential mark-to-market loss. Not consenting was risky as F&N contemplated triggering a strategic default otherwise.

In such a scenario, F&N could pay back bondholders at par, which was lower than the tender price. Nevertheless, bondholders from the two tranches were unfazed and rejected the bond tender. F&N relented by raising the tender prices and averted a technical default.

Although the promise not to strip away assets does not provide complete protection to the bondholder, it was useful to compel F&N to negotiate an acceptable outcome with the bondholders. Without the promise, F&N could simply have spun-off FCL without consulting with or providing bondholders with compensation.

In general, bondholders should study not only the presence of a promise not to strip away important businesses and assets, but also study the fine print to assess if the promise excludes key details.

Promise not to over leverage

Companies with pristine credit quality may not always remain so, especially given the low interest rate environment. Our team had lowered City Developments’ (CDL) Issuer Profile Rating twice, once in 2019 and another in 2020, from Positive (2) to Neutral (4), in part because net gearing surged from 12% to 93% in just two years after a series of acquisitions). Due to the high debt ratio and significant exposure to the loss-making hospitality segment, it is debatable if investors should continue seeing CDL as a company with strong credit quality.

We also saw Singapore Airlines (SIA) turning from a net-cash company to a company carrying significant net debt due to a planned $30.1 billion capex for fleet renewal. This proved untimely as, due to the onset of the pandemic, SIA was forced to idle most of its fleet.

Fortunately for SIA bondholders, the shareholders, especially Temasek, have been highly supportive by injecting significant amounts of fresh capital. Not all shareholders have been so generous; the pandemic has delivered the final blow for over 40 airlines globally.

Note that bonds of both CDL and SIA, like many other companies which are or were once pristine, do not contain promises to limit the amount of borrowings. In other words, these companies may increase the gearing and debt levels regardless of the support of bondholders.

If it is impractical to avoid the high-grade or once high-grade companies, investors may monitor company developments or corporate actions (like acquisition, capex or changes to working capital) requiring significant capital commitment.

Promise not to prioritise payments to equity holders over debt holders

When a company defaults on its bonds, bondholders have priority claims over equity holders on the residual value of the company. However, we find that the priority of payment is not always preserved prior to default.

Before Hyflux’s trading suspension and court supervised reorganisation in May 2018, it made a dividend in specie to ordinary shareholders in HyfluxShop Holdings (HyfluxShop) worth $14 million in February 2018. It also provided another $20 million in capital to HyfluxShop via preference shares. In total, $34 million of value was carved out of Hyflux via HyfluxShop.

Hyflux continued to pay distributions to ordinary shareholders and holders of preference shares and perpetual that exceeded the profits made over 2016 to 2018.

While stoppages of these distributions may not necessarily have prevented Hyflux from tipping into default, the total amounts distributed ($184.8 million from 2016 to 2018) are significant relative to restructuring proposals received from potential investors ($200 million to $500 million) — if such distributions had been retained, eventual recoveries could be higher.

For REIT perpetuals, covenants are weakest amongst corporate bonds — there is no need to make good on any missed distributions, which allows REITs to effectively subjugate perpetuals to unitholders. For example, it is theoretically possible for a REIT to miss payments to holders of its perpetual (perpholders) for the next 10 years to save on interest.

Perpholders of Lippo Malls Indonesia Retail Trust (LMIRT) recently experienced a close shave when the REIT contemplated withholding distributions last June following the closure of its malls after the pandemic outbreak and subsequently missed the December 2020 distributions.

Fortunately, this was made good through an optional distribution in February after LMIRT completed a rights issue.

Thus far, LMIRT appears to be the exception to the norm. While REITs have the choice to defer and miss distributions, the vast majority did not do so. Perhaps, the risk of distribution deferral is mitigated by the reliance on perpetuals as part of the capital structure.

If a REIT were to miss a distribution, it would be difficult for the REIT to return to the market to raise a new perpetual. So far, most REITs have erred on the side of caution by retaining cash and reducing distribution payout ratios to unitholders last year.

Promises are a shield, not a sword

Promises can provide protection against actions by shareholders which injure bondholders (like the limit the amount of debt taken, prevent assets from being stripped away) and can also ensure that bondholders are paid before shareholders (restricting dividend payments if the company is not profitable, for example).

Other promises to consider include not to pledge assets or cash flows to other creditors, compensation when the controlling shareholder changes or when the company delists and not to materially change the line of business. We see promises as shields that help to lower the risk in owning the bond.

However, shields seldom offer complete protection. Even the most well-meaning promises allow for certain exceptions such that it does not disrupt the ordinary course of business. For example, developers are allowed to sell properties; it would be impossible to conduct business if the non-disposal covenant restricts developers from selling properties.

The example illustrated by F&N also shows that promises do not directly prevent a determined controlling shareholder from attempting to extract value from the company at the expense of bondholders, though having a shield is better than none.

Aside from protection coverage, there are limitations in the type of protection that promises confer. Unlike shareholders, bondholders do not have voting rights and should not expect to significantly influence the direction of the company. Promises are also not meant to provide effective shelter against bad investments or industry headwinds.

For example, a number of offshore and marine companies in 2016 to 2018 (like Swiber Holdings, Nam Cheong and Ezra Holdings) reached out to bondholders seeking their consent to waive promises to avoid a technical default.

Bondholders were presented with little choice but to agree. Otherwise, recoveries looked uncertain if the companies in stress were to tip into default.

Given the significant industry headwinds, even with well-crafted promises, most companies in the offshore and marine sector eventually defaulted. In another example as of writing, onshore Huarong bonds which are structured with better protection than its offshore bonds are beginning to be sold off. This is mainly due to the uncertainty over Huarong’s credit profile, the risk which promises does not help to mitigate.

Promises are essential to safeguard the interest of bondholders. In addition to studying the credit fundamentals of the company, investors should examine the adequacy of protection provided by promises.

Fortunately for investors thus far, most companies which offered limited promises have not defaulted on the bond principal and interest.

However, there have been numerous examples as illustrated in this article where a weakening in credit fundamentals of the company increases the importance of the promises made.

While there is the temptation to overlook promises in a hunt for yield, do not count on the odds to be always in your favour.

Wong Hong Wei is a credit research analyst with OCBC