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Breach underlines importance of dim sum covenants

22 Aug 2012

Investors will press high yield issuers of dim sum bonds to incorporate covenants in their future bond issues after Global Bio-Chem warns of contact breach.

Market practitioners are cautioning the importance of covenants in the offshore renminbi, or CNH, bond market after news that Hong Kong-based Global Bio-Chem Technology Group is poised to be the first company to breach its covenants on its dim sum bond.

On Tuesday (August 21), Global Bio-Chem announced that it is facing a possible breach of covenants on its three-year, Rmb450 million (US$70.8 million) dim sum bond sold May 6, 2011 due to losses generated in the first half of 2012. That dim sum bond, its only CNH-denominated note, pays a 7% coupon. HSBC acted as bookrunner.

According to the bond’s offering circular, Global Bio-Chem has five financial covenants attached to its bond whereby it must adhere to specific requirement regarding its maximum leverage ratio, minimum current ratio, a fixed-charge coverage ratio, its dividends and its consolidated tangible net worth, the latter of which cannot drop below HKD8 billion (US$1.03 billion).

The company did not specify which of these covenants is in danger of being breached, though one fixed income source suggests that “in theory there are a few that they could have triggered”.

“It’s possible that with its weak first half of the year that its cash has come down, or it has marked down its inventory, or is has taken on bank loans that increased short term leverage – a combination of factors could have put the company in this position,” he added.

The notice of Global Bio-Chem’s possible breach of covenants came the same day that its board issued a profit warning highlighting expected year-on-year losses in the company’s interim results, due to increasing costs of raw material and a pricing drop for its lysine products.

Separately, the company halted trading on the Hong Kong exchange on the afternoon of August 20 after the board announced the death of Global Bio-Chem’s co-chairman Xu Zhouwen.

According to protocol, Global Bio-Chem will issue its results as planned and then will have 14 days to avoid a covenant breach. At this point, its bondholders will be notified of their options, and if 25% or more demand their investment back, then Global Bio-Chem will be required to accelerate the payment of investors’ principals immediately.

If this process ensues, Global Bio-Chem also has the option to seek a waiver to delay this payment.

Despite the company’s predicament, dealers and investors are praising Global Bio-Chem for its upfront handling of the situation, and insist that other high yield issuers follow its lead.

“Any company in this situation should inform investors as early as possible that it may breach a covenant and provide information on how it will be remedied – management needs to be open and honest to build credibility,” said Bryan Collins, a fixed income portfolio manager at Fidelity. “This is all standard practice in bond markets globally, and it is necessary to see this in the dim sum bond market as well, which is still in development. Ultimately covenants are there to protect both companies and investors.”

Global Bio-Chem also issued a statement seeking to reassure investors of its ability to repay its debt.

“The board would like to emphasize that the financial position of the group remains strong and the group has sufficient cash to honour the terms of the bonds and if necessary, to redeem the outstanding bonds immediately,” the company’s board released on August 21.

If the company does not have the ability to pay, it will follow a separate set of rules that apply to a dim sum default.

While dim sum participants are reassured that a system is in place in the event of a covenant breach, the reality is that most CNH bond investors lack this level of protection on their investments – especially on their high yield bonds.

“The risk here is that a lot of companies that don’t have covenants in their bonds, have little incentive to uphold their financial circumstances,” said Collins. “There are other companies in the high yield space, mostly in the dim sum market, that don’t have covenants, nor have credit ratings or debt instrument ratings.There are no safeguards for the investors of this debt.”

Fidelity research indicates that 40%-50% of the entire CNH bond market is unrated, though some debt has been issued by a parent that does have a rating.

Further to that, 30% of all dim sum debt is classified as high yield, or sub-investment grade, and it is this category that is especially covenant-light. “Effectively all high yield dim sum bonds, give or take a couple, have little-to-no covenants and have highly variable terms and corporate structures,” Collins said. “And a lot of these also have no ratings, because these companies know that if they sought one, they wouldn’t be investment grade.”

This situation puts dim sum investors in a precarious place, where they might not have a way of fully knowing how healthy a company is, nor have options to reclaim their investment without covenants to protect them if a company’s health deteriorates.

Global Bio-Chem, for example, does not have a credit rating and did not seek one for its dim sum bond. Yet its covenants act as a legal protection method to help investors despite its lack of ratings.

While Global Bio-Chem’s deal is small, one debt capital market (DCM) head says that the lessons learned during its ordeal are broadly applicable.

“There were certainly deals done in the very early days that didn’t have ratings and covenants, but the record for this has improved recently,” he said. “These deals were done in the frenzy of speculation that the renminbi currency would appreciate against the dollar, but now there’s been an adjustment of supply investors are more discerning of the instruments that they buy. This is another event that will help to promote the use of covenants.”

This may be met with resistance, however. Just as investors are looking to protect themselves with the use of covenants, high yield issuers will want the freedom of not being beholden to them.

Yet in the end, fixed income sources says that the investors will win, “because we are the ones lending on behalf of our investors, the borrowers have to do right by investors, otherwise we simply won't buy their bonds,” said Collins.

“The message that we see here is that is this will be just another step in the development of this market to create better covenants and better structured deals,” adds the DCM head. “This is a natural consequence of the market and is a trend that has been very much in place before Global Bio-Chem’s technical default. Clearly, this trend will continue to ensure that investors are in better control of the risks that they are taking.”

22 Aug 2012