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Covenant breach is welcome development for dim sum - opinion

27 Aug 2012

The dim sum market is poised to see its first covenant breach – which is easily one of the most positive developments in the offshore renminbi bond market in 2012.

When industry insiders give a wish list of developments in the offshore renminbi, or CNH, bond market, they speak of new tenors, size and scale of bonds, and the widespread geographies of their issuers.

While each of these has made for a very positive trajectory for dim sum in 2012, there is one development that’s even more valuable: the experience of having the first covenant breach.

The market is on the cusp of this now. On Tuesday (August 21), Global Bio-Chem Technology Group announced that it is facing a possible breach of covenants – a first in the CNH market. The full meaning of its announcement is yet to be understood, but Global Bio-Chem is expected to elaborate on its message in the coming days.

In the meantime, dim sum dealers have already been preparing their responses to questions regarding high yield credits and the nuances between covenants.

Essentially, even the idea that the market will witness its first breach offers dealers the soapbox they have been waiting for to educate issuers and investors alike - and get them on board to the idea of covenants.

Global Bio-Chem’s highly publicised trial with its covenants is relevant because it is one of the few high yield issuers to have them.

In fact, the vast majority of dim sum bonds don’t have ratings, either. (Fidelity data suggests this is as much as 50% of the market). This is because bond sellers believe that, if they seek a rating, they would be sub-investment grade, and that branding would force them to pay up on their bonds.

That means high yield dim sum investors have very little protection: there are no ratings to alert them to the creditworthiness of a company, and without covenants there are no parameters to keep companies in check.

While this has been improving as investors become more discerning about the credit they invest in – demanding that more companies use covenants - it’s still a mission to get high yield issuers to adopt them.

Global Bio-Chem is about to be the poster child for this motion, however.

Global Bio-Chem, which does not have a rating for its three-year, Rmb450 million (US$70.8 million) 7% note, has played by the book through this whole process.

It first alerted investors to the possibility of breaching its maintenance covenants earlier in the week, and at the same time told investors of losses generated in the first half of 2012.

It promised to follow up with more information, but first moved to reassure investors that the company’s overall fundamentals are healthy, and if necessary it would be able to repay investors’ principals in full.

It acted quickly and pre-empted further concerns about its financials. And if all goes as expected, this event will mere be a technical default by the company – which dealers insist isn’t a big problem - rather than a full default.

In short, this is a story of covenants doing their job.

Issuers will undoubtedly continue to resist the adoption of covenants, but with Global Bio-Chem as an example, investors will only want them more, realising the risks associated with high yield investing.

And in the end, they’ll win out by speaking with their feet.

Further, leading dim sum dealers are already expecting a rise in incurrence covenant use, merely because issuers are more clued in to ask about them. This highlights another benefit of this event: issuers and investors are asking more questions about what they’re seeing, and want to know all their options.

Asking these questions will only do more to develop the market and create stronger standards, which will help to draw more investors and a broader array of credits.

Looks like dealers might get their wishes granted after all.

27 Aug 2012