In Part 2 of this three-part product briefing, several market practitioners explain the steps and players involved in the process of structuring and pricing high yield bond deals, and also look at the components of successful deals as well as what to watch out for.
Date: July 2010
When putting a high yield deal together, the main market players include: the issuer of the bond; the investment banks who facilitate the structuring of the bond and play the go-between for the issuer and investors; the lawyers who document the deal; and the accountants who work on the financial disclosure to help the investors make their decisions.
According to Colin Blackwell, chief operating officer and investment committee chairman at Singapore-based Opvs Group, investment banks in Asia typically talk to company treasurers and owners about their various financing options. Control is a big issue, he said, especially with family-run companies, where giving up equity is not something which they want to do if they can avoid it – leading them to the option of bank loans or bonds.
Typically, investment banks go through beauty parades, explained Florian Schmidt, managing director and debt capital markets for ING Bank in Asia, based on their knowledge and experience of the company, product and industry – and their ability to devise the right structure for the deal.
The first part of the process is then helping companies to get a rating, said Blackwell, explaining that unrated Asian companies need to work with the ratings advisory teams at the investment banks to get the best possible rating.
Then the investment banks start to do the structuring and other work, he said, including positioning the credit and also how the company fits into the country and industry stories.
Lawyers acting for the company and the investment banks focus on doing the disclosure and due diligence to create the offering document with confidence that everything is complete and accurate, said Anthony Root, head of the corporate practice for Milbank, Tweed, Hadley & McCloy LLP in Asia.
The draft offering document provides all the risk factors, added Blackwell, as well as the description of the company and industry for investors.
Not included in the offering document are the financial projections, said Root, given that nobody wants to take responsibility for forecasts. Companies therefore use historical information and identify trends to enable investors to extrapolate trends to get some indication of future prospects.
Another aspect of the banking process to help provide information of future prospects is through the analyst report, he added, which comes from a separate division of the investment bank.
Once banks have an offering document ready, Schmidt said they start to talk to investors and do roadshows. Some investors like to also provide ideas on structuring, he said, which is important to do before any deal is launched and made public.
A physical roadshow involves doing one-on-one meetings with a series of investors, he explained, followed by the launching and pricing of a transaction
The high yield bond market has a large iteration process between an issuer and the investor base collectively, said Jeremy Amias, director at Amias Berman & Co in Hong Kong, explaining that this can be a long process.
Issuers often need to add certain features to attract investors and ensure the saleability of the deal, he said, especially for newer issuers, for example equity kickers or putting up some kind of assets against the deal.
Root said there is a lot of dialogue between the company and investors – directed by the investment banks – to meet the needs of both sides and balance everyone’s interests.
The due diligence process
According to Root, the first type of due diligence is called management due diligence. This is done early in the transaction to understand the company’s story, in order to determine the extent of the covenants and what information should go into the offering document.
This involves a general discussion with the company’s senior management, he explained, which is generally done over one to two days through a Q&A process.
It is an effective way of getting to know the company, said Root, as well as laying the foundation for the marketing story which the bankers use to sell the deal, and for the information that the lawyers use to write the offering document.
Documentary due diligence is then done to back this up and ensure that all descriptions in the offering circular are based on valid information, he added.
Root said financial due diligence is done in conjunction with accountants and in the form of a Q&A to go behind the financial process to understand the sufficiency of the controls in place.
This is important to provide the numericals required for the covenant package, said Schmidt.
This then has to be negotiated with the company and the market depending on investor feedback.
According to Root, the aim of this combined due diligence process, which can take place over a period of anywhere from 4 to 6 weeks – or potentially up to a year or two in very complex situations – is to encapsulate everything in an offering document.
If done to US standards, which Root said are typically the highest international standards, the lawyers issue what is known as a 10b-5 opinion. This indicates that they are comfortable that the company, the bankers and the accountants have produced a full and fair summary of the company’s business, operations and prospects, including all information an investor needs to know to make an informed decision.
Factors affecting pricing
Default rates and ratings are key factors which affect the pricing of high yield bonds, said Schmidt, explaining that the higher companies are rated, the lower the yield – and vice versa, and the higher the default risk of the rating or industry, the higher the yield – and vice versa.
Competing supply is another important factor in determining pricing. For example, said Schmidt, if a number of high yield issues come to market at the same time, especially from the same industry, investors might display high levels of fatigue and therefore ask to be compensated for taking a new deal into their portfolio.
At the same time, said Amias, when a deal is priced, it is important that people are ready for it in case they want to hedge themselves. This isn’t always the case with high yield deals, however, as people are taking more of a credit view than a market view.
Structure also plays a key role in pricing, added Schmidt, so people look at whether the covenant package and subordination are appropriate for the business.
Any structural elements to mitigate risk are also taken into account, he added. For example, high yield bonds can be issued at a holding company level, but if there are operating company guarantees in place, then it is as good as issuing directly from an operating company.
Successful high yield deals are those which help issuers achieve their objectives by raising the required funds at the coupons they are comfortable with paying to investors.
And the banks also need to ensure that the order book is a quality order book, meaning that there should not be too many fast-money accounts who are looking to trade the bonds. This would lead to more bonds being offered than being bid, and therefore the price going down, said Schmidt.
According to Root, a key part of the quality of a high yield deal is related to its overall process. If there are good investment banks, good law firms and good accountants involved, then the potential for there to be structural problems is much less, he explained.
While there might be an industry problem or a company-specific problem, the potential of either overly-restrictive or too-generous covenants is reduced.
For new issuers, high yield bonds represent a benchmark exercise, added Schmidt, explaining that it is the first time they have a rating, the first time they have a transparent and independent judgement on their credit quality, and the first time they have a pricing reference.
The biggest danger of the high yield process, said Root, is when issuers don’t fully understand the structure and covenants of the deal they have done, and they might therefore potentially disregard the covenants.
A company entering the capital markets should do so for the future, he said, rather than on a one-time basis.
The reputation and personality, as well as investors’ views, of the company, are sometimes formed by the first deal, he explained. So if the company makes announcements soon after a deal which are inconsistent with what the company said was going to happen, then investors will remember that when it comes to future deals.
It is also important to make sure that high yield deals don’t get too over-subscribed, added Amias, requiring the bankers to manage this process and control the bond distribution and trading carefully.
In addition, having too many lead managers can result in nobody being accountable enough. Ideally, there should be two or three lead managers only, he said.
Publicity around a deal also needs to be managed and controlled, added Root, to ensure the bonds are only sold with complete information via the offering document. So where companies are used to talking more freely to the media, analysts or potential investors, they cannot do this during an offering in a way which might condition the market.
Regulatory issues with high yield bonds
Given that high yield bonds are sold to sophisticated investors, Root said they are typically outside the regulatory environment. As a result, these deals can be subject to less scrutiny, assuming the companies are not listed.
However, in comparison with markets which have developed legal systems, in turn ensuring that a company’s obligations are very clear, Blackwell said that in some Asian countries with under-developed legal systems, borrowers can more easily walk away from their obligations – to the detriment of bondholders.