Demand for stricter covenants by investors is less pronounced for Chinese high yield bond issuers compared to Indonesian deals, underscoring the fact that China’s high yield bond market is less mature.
Investors who chase Chinese high yield bonds are mainly driven by the yield pick-up and are not entitled to onshore company guarantees, which deter investors from demanding stricter covenants, according to a senior debt capital markets banker.
“It’s not what I would call sophisticated demand [in China] in terms of what I think about covenants and credit and protection,” according to a senior debt banker who specialises in Asian high yield bonds.
One of the major reasons why covenant demand is lighter in China is due to the fact that the country’s strict capital controls require entities incorporated in China with cash flows generated from China to issue offshore bonds via an offshore vehicle.
The offshore vehicle often takes the form of a holding company (also known as the offshore parent company), effectively preventing offshore bond investors from becoming direct creditors of the onshore operating company. The structure of the company gives little incentive for investors to ask for additional covenants because the onshore company is not able to provide a guarantee to the offshore holding company in case of a breach of covenants or a default.
“China is largely all holdco [holding company] deals with no upstream guarantee whatsoever. I think those structures are a bit weaker [compared to the Indonesia deals],” according to another senior banker based in Hong Kong.
“Because of that structural weakness, ultimately there are limits to how many bells and whistles you can throw on to it because you are not at the operating company [level],” according to the senior banker. “You can only do so much to enhance credit given the fundamentals of how it all works. In Indonesia there’s less of that [since] you do have a guarantee from the operating company.”
In Indonesia’s latest high yield deal, investors requested that real estate developer Jababeka International add in a 20% amortisation schedule in the final two years of the US$173 million deal before it was printed in July 20, according to bankers.
The amortisation schedule added to Jabebeka’s deal follows similar instances that kicked off in 2010 with Indonesia’s Star Energy and Cikarang Listrindo, giving precedent to future deals to add additional investor protection.
Extra covenants has helped Indonesia’s high yield credits gain a competitive edge against Chinese credits, in addition to the fact that they provide diversity compared to the majority of property developer names that dominate the Chinese space, said a head of credit trading at a foreign bank.
That’s why Indonesia’s credits trade at a range of 5%-7%, where the best Chinese names like Agile Holdings Property and Shui On Development are trading at 7%-7.5%, according to the senior trader.
“People prefer Indonesia over China because of diversity. People are willing to look at smaller companies [in Indonesia] but would want that extra protection,” said the trader.
The stronger presence of private banks in Chinese high yield deals is also a major factor that has watered down attention to covenants, said the senior debt banker, as a higher return was a top priority for some investors, rather than examining the protection on their investments.
“There is a fair reason to believe that is why you see this more in the Indonesian than the Chinese deals. A lot of the lower end is just driven by a lot of private bank demand which is less sensitive to the covenant issue. They’re yield junkies. Whereas the Indonesian market is less driven by the private banks’ demand and more driven by fundamental investors, hedge funds, credit investors and high yield mutual funds and they’re more sophisticated and have more issues with covenants,” said the banker.
“They are [China high yield investors] are not going to say, ‘I like it at 12% only if I get covenant changes.’ They will say, ‘I like it 13%.’”
In the latest Chinese high yield deal, the largest segment of investors for real estate developer SOHO China’s US$1 billion, 5.75% coupon issue that printed on October 31 came from private bankers. They took 52% of the demand, followed by 40% from funds, 5% from insurance and corporations and 3% from banks, according to Dealogic. CITIC Pacific’s US$750 million deal that printed October 8 was also dominated with a 52% presence from private banks.
That compares with Indonesian names, where Theta Capital’s US$150 million deal on May 9 that was guaranteed by PT Lippo Karawaci. The investor base was split with 39% from private banks, 55% from funds, and the rest by insurance companies and banks. Listrindo Capital BV’s US$500 million deal printed in February 13 was scooped up mostly by fund and asset managers, who took up 67% of the demand. Only 18% of it was allotted to private and retail banks.
Chinese high yield bond issuance has reached US$8.1 billion so far this year, compared to US$7 billion in 2011, according to data provider Dealogic. That compares with Indonesia’s US$1.6 billion so far this year and US$2.9 billion in issuance last year.