NO ONE ENJOYS getting insulted – unless, perhaps, they’re a masochist or a contestant on a reality TV show. But it seems investors in high-yield bonds these days are looking to get in on the act. According to veteran high-yield fund manager Philip Milburn of Kames Capital, which runs two high-yield bond funds, investors are now embracing debt structures that are – in words he used recently in addressing fund selectors at the Kames head office – “at best questionable, and at worst downright insulting”.
He has a point. The most recent addition to the suite of insults that investors in European high-yield have been happy to take on board is the portability clause. This is the flip side of the change-of-control put. Instead of becoming puttable, bonds remain untouched in the event that the issuing company undergoes a change of ownership.
The sort of covenant erosion Milburn has warned about is rife in Europe, and the portability clause its most potent marker. M&A is making a comeback, and investors in debt with portability attached need to factor in the real risks of buying paper that may end up as the obligation of a company rather different from the one in which they initially invested.
The room for shenanigans inherent in this structure strikes me as pretty vast. In the event of an LBO, a savvy buyer could effectively end up slamming a vast amount of the target’s existing debt right down the capital structure. You thought you were near the top of the structure in the event of a debt restructuring, and then find yourself deeply subordinated.
The room for shenanigans inherent in this structure strikes me as pretty vast
WE HAVE YET to see egregious covenant erosion in Asia, but if the issuance bonanza continues, I imagine it will start to creep in. Inbound M&A has always been muted in the region (excluding Australia) given Asian families’ traditional aversion to dilution. Indeed the COC features often included in Asian high-yield issuance have always seemed rather a meaningless add-on for this reason. Still, if a raft of business owners look to cash out at what they perceive to be the peak of the business cycle, we might yet see the introduction of portability in Asia.
The surge of the so-called “high-yield lite” market in the US and the array of advantage it has given to issuers will not have been lost on Asian companies. With the Barclays high-yield index recently hitting a yield-to-worst of 5.03%, just shy of its all-time low of 4.95% last year, you have to ask whether we are in an era of “it’s different this time” or whether the skill of pricing risk appropriately has vanished in a feeding frenzy that will have a rather unpleasant denouement.
Of course the US is a different risk proposition to Asia, where numerous countries fall far behind in terms of corporate governance and accounting transparency. The “Asia premium” used to materialise in the form of double-digit yields, a few coupons in escrow and an array of leverage covenants. This was particularly true of issuance from Indonesia, where the country’s heavy-handed treatment of offshore investors in debt restructurings resulted in a premium to be paid for offshore issuance.
But last year we saw Gajah Tunggal issue five-year US dollar bonds at the 7.95% area and on loose covenant terms, in perhaps the first sign that “high-yield lite” could emerge as a distinct asset class in Asia. Indeed, the fact that Gajah’s deal found a high level of US participation suggests that investors are extending their geographical reach in the ongoing quest for yield.
I WARNED IN this column a few weeks ago of the dangers inherent in low volatility, and the warning deserves to be reiterated since it seems little can knock risk pricing these days – not even a rather sinister military coup in Thailand. As former government ministers disappear into Thai military custody and the real possibility of civil war hangs like the sword of Damocles over the country, what does Thai CDS do? It barely moves.
I recall years ago, when Pakistan was in danger of default and presented as a failed state, its CDS ballooned to the 2,500bp mark at five years. That seemed at the time an entirely appropriate response to the mess the country found itself in. And yet Thai CDS is around the 120bp mark, barely changed from its level before last week’s coup.
This after the tanks rolled in, after the newly installed military junta suppressed mass media and censored the internet, and after the arrest of more than 200 former government members. Just what does it take these days to register as extreme event risk? I’m just not sure. In the meantime, Thai oil major PTTEP begins marketing dollar and baht bonds. You couldn’t make it up.
Well, if this sanguine attitude to risk represents a new paradigm in the debt markets, we should prepare for the willingness of global investors to take on board insults from Asia of the financial kind. Portability clauses appearing in Asia? I give it six months.