In Part 1 of this three-part product briefing, market practitioners talk about the key features and characteristics of high yield bonds – including why companies issue them, basic structures and related issues, the main risks, and the history of the market globally and in Asia.
Date: July 2010
Tags: High yield bonds, Debt, Yield, Risks, Liquidity, Rating, Default, Covenants, Diversification, Subordinated
Basic features of high yield bonds
High yield bonds are non-investment grade debt securities. This means that the highest rating a high yield bond can have is BB by Standard & Poor’s and Fitch Ratings, or Ba1 by Moody’s Investors Service.
A purest would consider real high yield to be below-investment grade bonds in developed countries, said Jeremy Amias, director at Amias Berman & Co in Hong Kong, where the issues relate to credit and structure, rather than being influenced by the credit rating of the country where the issuer is located.
According to Anthony Root, head of the corporate practice for Milbank, Tweed, Hadley & McCloy LLP in Asia, high yield bonds are essentially a form of debt with covenant structures similar to bank loans, but designed to avoid the need for individual bank consent and review, given that these tend to be tight.
Some market commentators, however, would consider bonds issued by banks which are non-investment grade and without a covenant package to be high yield, said Florian Schmidt, managing director and debt capital markets for ING Bank in Asia. Or bonds issued by agencies such as state-owned utilities companies without an investment-grade rating. Or even non-investment grade sovereign bonds.
Schmidt said the key reason why companies issue high yield bonds is because they don’t have access to bank lending. Which means they are companies which are fairly early in their lifecycle and not yet necessarily listed or able to draw substantial bank lending.
Issuers decide whether they want to issue equity or debt, added Amias; if they decide on debt, they then choose whether it will be through the bank loan market or some other format.
High yield issuers are typically from sectors which show strong growth, or which are capex intensive (or a combination), explained Schmidt.
In the US, high yield bonds are issued from companies across all industries, he said. Many Asian issuers, however, are from the Chinese real estate sector, the Indonesian natural resources sector, or the TMT (technology, media and telecoms) sector.
The attraction of high yield bonds
According to Schmidt, high yield bonds are among the most flexible debt products available, making them very attractive to issuers.
For those entities which do have a choice, high yield bonds represent very substantial diversification of the investor base, he explained, away from the bank market into the institutional investor market – for example asset managers, mutual funds, hedge funds, prop desks, private banks and commercial banks.
On an average high yield bond, he said there might be 150 to 200 investors on the book.
Having alternative investors through high yield bonds is a very valuable tool for corporate, added Schmidt.
So while high yield bonds are more expensive compared with the syndicated loan market, they provide good access to capital.
On a micro level, Schmidt said that high yield bonds typically have bullet redemptions after 5, 7 or 10 years. So rather than bank loans, which are amortising, companies can benefit from the bullet structures by deferring a substantial drain on their cashflows.
As a result, for companies which are reasonably cashflow intensive in the early stages of their life, Schmidt said high yield bonds provide various advantages.
Basic structures and covenants
US-style high yield bonds are subordinated in the capital structure, explained Schmidt, ranking behind senior secured debt. In Asia, high yield bonds are often issued at the holding company level, which means that through the bond, investors don’t necessarily have direct access to the cashflow of the operating entities – especially in China.
But there is protection through a series of covenants, he said – typically incurrence covenants, applicable to a restricted group of subsidiaries of the issuing entity.
Root said covenants are structured around the ability to incur debt and prevent value leaking from the company.
This might be through forcing a degree of repayment of the bond in certain circumstances, explained Colin Blackwell, chief operating officer and investment committee chairman at Singapore-based Opvs Group. Or through a cashflow trap, whereby parts of the cash generated from the business are ring-fenced for the benefit of bondholders.
According to Root, bank debt involves much tighter covenants than high yield bonds on the assumption that the company will typically ask the bank for a waiver. It will generally get this because the bank debt is only held by a small number of lenders, whereas high yield bonds are held by dozens, or perhaps hundreds, of investors, making it difficult and awkward to get consent, he explained.
A key covenant is one which generally limits additional indebtedness unless there is sufficient cashflow to support that debt.
Carve-outs exist for permitted indebtedness, said Schmidt, which are important in some industries to avoid impairing the flexibility of certain companies to grow or go about their business.
Other important covenants restrict certain payments, added Schmidt, to ring-fence assets or cash from leaving the restricted entity, and prioritise cashflow for the benefits of senior creditors against junior creditors.
There is a concern from investors in Asia that some companies don’t distinguish between family assets and corporate assets, explained Root, so there is a restriction on the ability of the issuer to engage in related-party transactions unless that transaction is for value purposes and gets certain approvals above certain thresholds.
There is also a change-in-control provision, added Schmidt, so that if there is a change which breaches certain thresholds and makes investors uncomfortable, they have the right to put the bonds back to the issuer.
In general, he said that covenants are intended to maintain or improve an issuer’s credit rating. They are not structured to be used against the issuing entity – instead their aim is to synchronise the interests of management, shareholders and noteholders.
Key risks of high yield bonds
In terms of risks, the main issue with high yield bonds is default risk. Another key risk is liquidity, especially in bear markets.
There is a shortfall in liquidity in Asia, explained Schmidt, given that there are not enough market-makers, and those which are here are not committed enough.
Duration risk is also significant, added Binay Chandgothia, chief investment officer for Principal Global Investors in Hong Kong, so investors need to carefully manage this aspect of their portfolio.
Other risks include correlation, industry-specific issues and interest rate movements, said Schmidt.
The history of the high yield bond market
Michael Milken created the modern high yield bond market when working at Drexel Burnham Lambert in the late 1970s and 1980s.
Until that time, Blackwell said the bond market was driven by high-quality issuers, and it wasn’t possible to sell a bond which didn’t have an investment-grade rating.
But Milken found a gap in the capital structure between equity and investment grade debt, explained Schmidt. Milken felt it was unfair that rapidly-emerging yet solid companies with decent management and sponsorship could not access the bank market or the capital market.
As a result, Milken created the investor demand for the debt of smaller, fast-growing companies, said Blackwell. The selling pitch to insurance companies and other institutional investors prepared to take the risk of buying this debt was that the increased yield they would receive from buying these bonds more than outweighed the increase in default risk on their portfolio.
Milken – and Drexel Burnham Lambert – also guaranteed liquidity for investors, said Schmidt, showing that they realised it was critical to make a market in these new bonds. Without this positive experience, the product would never have been able to have been incepted, he said.
Companies also then realised that they could choose whether to leverage their balance sheets by taking on more debt, said Blackwell, resulting in a downgrade of their credit rating to speculative grade, yet still with the ability to finance themselves through speculative ratings.
High yield then developed into a fully-fledged asset class in the US, diversified across a number of industries, before moving into Europe.
In fact, added Schmidt, a lot of big US companies today started out as high yield issuers – corporate America has therefore been shaped by the high yield product.
High yield bonds in Asia
In Asia, high yield bonds have taken some time to take off, with the region having an idiosyncratic investor base, said Schmidt. However, it is gradually evolving.
Some Asian issuers are non-investment grade mainly because of the sovereign rating ceiling, explained Amias, despite those companies often being no different to many investment grade names.
The first attempt to implant the high yield product into Asia was before 1997, explained Schmidt. However, this failed with the Asian financial crisis and the US$13.9 billion default of Indonesia’s APP.
The problem was largely fuelled by bank investors in search of high returns rather than doing sound due diligence, he said, adding that the overall approach to evaluating high yield and incorporating it effectively in portfolios was embryonic at best.
The second approach was made between 2004 and 2007, said Schmidt, with the approach to high yield bond deals becoming more professional and disciplined.
A lot of international investors had set foot in Asia by then, he explained, effectively running their portfolios out of the region. This created a growing number of real money accounts as well as fast-money investors such as hedge funds and prop desks, as well as some private banks.
However, said Root, there is still little high yield debt in Asia outside of certain sectors in China and Indonesia
As a fund investor, therefore, Blackwell said it is difficult to get proper diversification from the Asian high yield market. So while there are many Indonesian, Chinese and Philippine high yield issuers, he said that the market lacks issuers from triple-A or double-A rated countries such as Hong Kong or Singapore – showing that these corporate are yet to positively take the decision to borrow more debt and adjust their balance sheets down to non-investment grade status.
The Asian market is modest in size, explained Amias, and comes and goes sporadically.
