Llinks Corporate Finance Bulletin May 2012
If you would like other Llinks publications, please contact:
Roy Guo: (86 21) 3135 8756 [email protected]
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郭建良: (86 21) 3135 8756 [email protected]
A high-yield bond1 usually refers to a bond with a credit rating lower than the investment-grade.2 This high risk debt finance product has become common in the international financial market. This article briefly describes product features, structure and legal issues related to high-yield bonds in mature overseas markets, such as the United States and analyzes China’s high-yield bond market.
Development of High-Yield Bonds
High-yield bonds date back to America in the 1920s. Until the 1970s, US junk bond issuers were companies with non-investment grades due to their poor financial condition. In the mid-1980s, after surge of mergers and acquisitions in the US, especially hostile takeovers and leveraged buyouts (LBO), Michael Milken created junk bonds to help raise money for acquisitions. They were favored by some banks (mainly mutual saving banks), insurance companies, funds and other institutional investors, and entered a period of fast-growth. However, the junk bond bubble burst in 1989, and in November 1990, the spread between junk bonds and the US Treasury bonds reached 1,100 basis points.
In the first half of 1991, the junk bond market started to recover, and in 1995 the US junk bond market was worth US$200 billion. During the US financial crisis in 1998 and the collapse of the dot-com bubble in 2001, high-yield bonds took a hit. In 2005, Ford Motor and General Motors issued nearly US$80 billion of high-yield bonds, which prompted another recovery in the junk bond market. Up to 2007, the volume of US high-yield bonds reached US$1,000 billion, comprising 20% of the corporate bond market. However, with the start of the so-called the most serious financial crisis in the century, the high-yield market crashed again. At the height of the financial crisis in 2008, the yield spread between corporate junk bonds and the US treasury bonds reached 2500 basis points. The high-yield market gradually recovered in 2009. A number of investment-grade companies have been downgraded due to financial crisis, so there has been an increase in the number of issuers of high-yield bonds and more junk bonds have been issued.
High-Yield Bonds: Product, Market and Law
Generally speaking, since the 1980s, high-yield bonds have been considerably fluctuating in the market. As the economy deteriorated, the high-yield bond market sold off dramatically and investors suffered great losses; as the economy recovered, yields of junk bonds improved. Comparing returns between 1978 and first half of 2005, some observers found that returns of high-yield bonds exceeded that of 10-year treasury bonds in some years; but for the whole 27-year period, both the arithmetic annual return and compounded annual return of high-yield bonds exceeded that of 10-year treasury bonds by 230 basis points.
High-Yield Bond Issuers
Original issuers of high-yield bonds were companies downgraded below the investment grade, so called "fallen angels". As the market develops, other issuers are turning to the junk bond market. In the current global high-yield bond market, there are four kinds of issuers:
¾ Emerging or start-up companies: this type of issuers includes newly set up companies and small and medium-sized enterprises (SMEs) with short operational histories and weak balance sheets. They have very good development prospects and could access to capital markets through listings.
¾ Corporate acquirers: in an ordinary acquisition or LBO,3 an acquirer can issue high-yield bonds to finance its acquisition.4 In an acquisition, the acquirer may directly issue high-yield bonds to help pay for the acquisition or after the completion of the acquisition issue bonds to repay bridge loans provided by commercial banks, investment banks or other institutional investors. In 1989, KKR issued US$4 billion of high-yield bonds to help pay for its US$31 billion acquisition of Nabisco.
¾ Over-leveraged companies: companies in this class include blue chip companies with debt ratios exceeding the average and companies undergoing insolvency proceedings. Under provisions of Chapter 11 of the US Bankruptcy Code, an insolvent company might attempt to raise money for reorganization by issuing high-yield bonds.
¾ Capital-intensive companies: it can be seen that in the global market that capital-intensive companies such as cable TV companies, oil prospecting and chemical producers might raise funds in the high-yield market.
There are no specific industry requirements for issuers of high-yield bonds. According to Thomson Financial, in 2007 high-yield bonds were issued by businesses from 10 sectors, such as, energy & power, finance, raw material, manufacture, media & entertainment, healthcare, telecom, consumer services and high-tech.
As we can see from the structure and industrial distribution of issuers, high-yield bonds could, to some certain extent, facilitate SMEs’ financing, but overall, SMEs are not mainstream issuers of high-yield bonds. If China launches high-yield bonds, large capital-intensive companies may be given priority access to the high-yield bond market.5
Maturity of High-Yield Bonds
In the US bond market, the usual maturity of a corporate bond is 1 to 30 years, but some bonds have been issued for up to 100 years. For example, in the late 1990s, there were approximately 90 corporate bonds issued with maturities of 100 years. Bonds with maturities of 1 to 5 years are generally considered short term; with 5 to 12 years intermediate term. Long-term bonds are those with maturities longer than 12 years. High-yield bonds usually have terms of 5-10 years. Therefore, according to the US bond market rules, high-yield bonds are considered intermediate-term bonds.
The maturity of a high-yield bond is determined by the current status of issuers. When designing the maturity of high-yield bonds, we should look at hedging bond interest rates volatility risks as well as issuers’ financial status and fluctuation of economic cycles. If the maturity is less than 5 years, the issuer’s financial reality may not change radically, and issuers may default on their obligations when facing an economic crisis. For issuers with improving operating prospects, the longer the term of a high-yield bond, the higher the cost of financing.
For some growing companies, when designing the maturity of high-yield bonds, the issuers may be given a right to redeem bonds prior to maturity in the offering documents. Normally, the issuers have the right to redeem the bonds after three years. In the US bond market, some bonds issued in 1992 granted the issuer a limited right to redeem a portion of the bonds during the non-call period. For instance, an issuer paid off 35% of the bonds within three years of the issue. The issuer’s right to redeem may affect the liquidity of the bonds. In addition, if the issuer is granted a call option, we also need to consider that investors could own a put option to request the issuer to pay off the bond prior to the maturity date.
In the Chinese bond market, most bond maturities are 3 to 5 years, and it is difficult to sell bonds with maturities exceeding 5 years. Therefore, given Chinese investors’ appetite for risks, 5- to 10-year high-yield bonds would not be appealing to them. But from the issuer’s prospective, high-yield bonds with maturities of over 5 years will be welcomed by SMEs.
Coupon Rates of High-Yield Bonds
To meet investors' needs, high-yield bonds are usually fixed-rate. Through their 30-year history, coupon rates of bonds reached 25% of annual interest rates in extreme cases, but often, coupon rates in the US do not exceed 10% of annual interest rates. To reduce costs, issuers prefer to issue floating-rate bonds or products that allow them to reset interest rates.6
The issuance of high-yield bonds means heavy interest payment burden. Yet, most issuers may face periods of insufficient cash flow. Therefore, if interest is payable yearly, the issuer may be unable to make payments. To reduce this burden, over-leveraged firms prefer to defer interest payments for a period of 3-7 years. In the overseas bond market, there are three types of deferred-coupon structures:
¾ Deferred-interest bonds are the most common type of the deferred-coupon structure - these bonds sell at a deep discount and do not pay interest for an initial period, typically 3 to 7 years;
¾ Step-up bonds have the coupon rates that are initially low and then increase; and
¾ Payment-in-kind bonds give the issuers an option to pay cash at a coupon payment rate or give the bondholder a similar bond; the issuer can specify a period during which the issuer can make this choice.
Currently, Chinese bond investors focus more on fixed-coupon rate bond products. If high-yield bonds are permitted in China, only few coupon structures will be available, and the deferred-coupon structure should be the table.
Default Risk of High-Yield Bonds
The pressure of business incomes, cash flows and financial leverage on high-yield bond issuers is far greater than that on common bond issuers. Therefore, high-yield bonds have a higher risk of default. A default rate is a key indicator of bond risks. There are different ways to define a default rate. In its study, Moody’s uses the issuer default rate, that is, the number of issuers that default divided by the total number of issuers at the beginning of the year. Another measure is to use the dollar default rate, which defines the default rate as the par value of all bonds that defaulted in a given calendar year divided by the total par value of all bonds outstanding during the year.
In 2011, Edward Altman and Kuehne published a report on a study focusing on default rates for high-yield bonds. The study, which covers the period from 1971 to 2010, found that the default rate for high-yield bonds ranged from 2% to 5%, and exceeded 10% during the time of financial or economic crisis. For example, the default rate was 11% in 1991, 12.8% in 2002 and 11% in 2007-2008. The report also indicated that the default rate usually runs high at the end of a financial crisis.
Other than the default rate, recovery rates or default loss rates are also key indicators of high-yield bond risks. Measuring the amount recovered is not simple. The 30 years of development of high-yield bonds provides us with experience to measure default loss rates. For example, the average recovery rate is 38% for higher-level bonds, the default and recovery rates are inversely related to one another, recovery rates are relatively high in tangible asset-intensive industries, etc.
Default is an innate feature of bond markets and a bond market is not a normal market if there is no default. To promote the healthy development of China’s high-yield bonds, and given the frangibility of investors’ risk assessment capacity, we should take into account factors that prevent or reduce default risks when designing China’s high-yield bond system, and try to avoid the actual breach in early stages of development (5 to 10 years), such as, setting a higher market access threshold for issuers’ credit rating and longer maturities of bonds, as well as allowing issuing new bonds to repay maturing bonds or bonds in default.
Investors in High-Yield Bonds
In overseas bond markets, investors in high-yield bonds primarily are institutional investors, including mutual funds, pension funds, insurance companies and hedge funds. Very few individual investors directly hold high-yield bonds, but they can invest in high-yield bonds through bond funds.
¾ Mutual funds: according to Standard & Poor's, mutual funds represent approximately 35% of the investor pool. These bond funds might be funds that invest only in high-yield securities or bond funds that invest in both high-yield and high-grade bonds.
¾ Pension funds: according to Standard & Poor’s, pension funds account for 25% of high-yield investors. But due to the unique characteristic of pension funds, their investment strategy should be more prudent. Laws and regulations of all countries impose specific restrictions on the responsibility of pension managers. For example, in the US, pension funds are fiduciaries for retirement money and should act under prudent investment rules.
¾ Insurance companies: according to Standard & Poor’s, insurance companies account for around 16% of the high-yield investment community. In the US, insurance companies are allowed to invest their own capital or buy insurance products to invest in high-yield bonds.
¾ CDOs (Collateralized debt obligations): according to Standard & Poor’s, CDOs comprise 16% of the market, and as a capital management instrument, CDOs are backed by bank loans or bonds.7
¾ Hedge fund: Hedge funds and a small number of individual investors account for about 8% of the investor pool. From the perspective of the present international financial market, the presence of hedge funds in the high-yield bond market is increasing.
At this stage, insurance companies in China face many restrictions on investments in common corporate bonds, let alone high-yield bonds. Also we do not expect any short-term progress on pension funds’ investment in high-yield bonds.
Based on the experience of existing mature high-yield bond markets, China’s high-yield market also needs diversified, high risk-taking investors, and at this stage the cultivation of such investors is crucial to our market development.
Covenants of the Offering
High-yield bond issuers should make some specific covenants or commitments in their offering documents in order to ensure a reasonable balance sheet and cash flow as well as their ability to control subsidiaries. Next, I will briefly introduce some customary high-yield bond covenants.
¾ Debt burden
The debt covenant is designed to make sure the cash flow is sufficient to cover the existing principal and interest, and to prevent the issuer from bankruptcy due to excessive debt. Offering documents of high-yield bond covenants usually specify: unless the company’s EBITDA (earnings before interest, taxes, depreciation and amortization) have met the required standards, high-yield bond issuers and their subsidiaries are prohibited from incurring additional debts, including preferred equity issues.
If there are senior loans (such as bank loans) that take precedence over high-yield bonds and have to be paid back before bond holders, high-yield bond covenants typically specify: except the established debts, the issuer is not allowed to incur a debt (including loan and bond) with the same or a higher priority than high-yield bonds. If subsidiaries of the issuer have guaranteed high-yield bond payments, such subsidiaries are subject to the above covenants as well.
¾ Dividends
To ensure that the issuer has sufficient cash flow to cover the existing principal and interest, high-yield bond covenants may restrict dividends to shareholders or outward investment of bond issuers. For example, based on the issuer’s solvency and cash flow, the outward payment of cash is restricted to less than 50% of the issuer’s consolidated net income.
¾ Subsidiaries’ ability to pay
Given that high-yield bond issuers may use cash and assets of subsidiaries to repay the principal and interest of high yield bonds, high yield bond covenants usually require the issuer not to put limitations on issues, such as the payment of dividends to shareholders, provision of loans or transfer of assets from subsidiaries to the issuer.
¾ Lease
High-yield bond covenants may limit either an operating lease or a finance lease, e.g. the issuer and its subsidiaries are not allowed to enter into a lease agreement with a term of over three years and the rent for 12 consecutive months should not exceed a certain amount.
¾ Related transactions
This covenant usually specifies that, after the completion of a high-yield bond offering, transactions between the issuer and its subsidiaries and transactions between subsidiaries should be conducted at a fair value. A subsidiary is a company in which the issuer holds a certain percentage of shares, and transactions include lease, service, loans and guarantees, etc.
¾ The equity interest and debt of subsidiaries
The offering documents usually limit the issuer’s disposal of the equity interest in its subsidiaries at the end of the issue. For instance, the issuer shall maintain the equity interests in its wholly-owned subsidiaries and shall not amend the articles of association of non-wholly owned subsidiaries. Subsidiaries are not allowed to provide funds to the parent company.
¾ Merger & Acquisition
Unless otherwise agreed, the issuer shall not merge with other companies, take over other companies or become a subsidiary of other companies.
Offer Method of High-Yield Bonds
High-yield bonds are placed via a private placement, which means bonds are sold to a small number of chosen private investors. Private placements do not require complicated public offer documents, road shows and advertising, so it is a more efficient and time-saving mode than a public offering. Private placements are exempt from registration with the SEC under the US securities laws, while the registration application with the SEC for an initial public offering may take at least three months.8
However, more limits are imposed on the circulation and transaction of privately placed securities, such as that privately placed bonds are not tradable in the secondary market in a certain period after the offering (such a limit will have influence on the issuance) and issuers pay a higher rate to investors. This makes them less appealing to institutions that are able to invest only in freely-trading marketable bonds. The issuer of high-yield bonds usually makes a commitment to investors that the privately placed bonds will become publicly traded in the market for a time after the completion of the offering (typically not exceeding six months in the US). The issuers are required to follow securities registration procedures if their privately placed bonds come to the publicly traded markets of securities exchanges, and make public disclosures in compliance with the requirement for public offering. Therefore, the SEC has established a private-to-public debt exchange regime for converting privately placed bonds into public offering bonds, meaning that after completing the registration with the SEC, the issuer will offer public bonds under the same condition to high-yield bondholders as a replacement for the prior restricted bonds held by investors. In addition, it should be noted that, under the Rule144A, private issuers are still required to disclose their financial statements over the last two years to potential investors under relevant laws. In practice, due to concerns over antifraud regulations, the time taken to prepare documents for a private placement under Rule 144A is no less than for a public offering.9
Based on the US experience, it is suggested that China could also implement a private-to public bond exchange regime, and high-yield bonds should not be only private. Furthermore, to improve the credibility of the high-yield market, at the early stage of the high-yield bond market, regulators should implement measures to put pressure on issuers to improve the quality of their information disclosure.
Preliminary Conclusions
As we observe and analyze the growth pattern and prospects of overseas high-yield bonds, a simple analysis in number and size is insufficient. Over the past three decades, the high yield market has been expanding, but this expansion has closely correlated with an increase in the number of higher-risk institutional investors, and credit ratings downgrades worldwide has also had a major impact on the market size.10 We should be aware that the high risk characteristic of high-yield bonds does not change as the market expands and high-yield bonds play a limited role in easing financing pressure of small enterprises. If we position China’s high-yield bonds as a way to solve financing issues of small enterprises, the “high-yield bond market” that attracts close attention of market participants will not develop into a traditional market. Perhaps, just as CSRC’s chairman Guo Shuqing put it, “we are considering launching the SME Private Placement Bond as one class of corporate bonds, to attract market demand for, but not limited to, the high-yield bond.”
Contact Details
If you would like to know more information about the subjects covered in this publication, please feel free to contact the following people or your usual Llinks contact.
Shanghai Beijing Christophe Han Tel: (86 21) 3135 8778 [email protected] James Weng Tel: (86 21) (86 10) 6655 5050 - 1028 [email protected] Grant Chen Tel: (86 21) 3135 8669 [email protected] Wen Li Tel: (86 21) (86 10) 6655 5050 - 1027 [email protected] Wayne Chen Tel: (86 21) 3135 8766 [email protected] Calista Huang Tel: (86 21) 3135 8788 [email protected] Leo Wang Tel: (86 21) 3135 8716 [email protected]
© Llinks Law Offices 2012
1 A high-yield bond is also known as high income debt, non-investment grade debt, speculative debt, junk bond or high opportunity debt in some overseas capital markets.
2 Investment grade is the long-term credit rating assessed by credit rating agencies for debtors (or bond issuers), it is not a short-term credit rating (short-term debts are due within a year, such as CP-commercial paper). A bond is considered a high-yield bond if its credit rating is below “BBB” by the long-term credit rating standards of Standard & Poor’s.
3 In case of an LBO, an acquirer can repay high-yield debt and other funds with a target company’s cash flow from operations (CFFO) and the sale of shares, or money from the sale of capital or shares, after the break-up of the target company.
4 If the issue of high-yield bonds is to finance an acquisition, and takes place before the completion of the acquisition, different countries have different laws and regulations on whether the target company (including its subsidiaries) can guarantee the issue of high-yield bonds. In the US, such financial support is not a big problem in acquisition activities. However, in China many obstacles and problems still exist, particularly if the acquisition involves a state-owned enterprise.
5 However, with regard to the structure of China’s market players, capital-incentive enterprises engaging in power and energy businesses are mainly state-owned enterprises. Under the current credit rating system, these enterprises’ credit is supported by the government, so their credit is hardly rated below the investment grade. In the short run, only private enterprises have the potential to issue high-yield bonds.
6 The coupon rate may be reset annually or reset only once over the life of the bond. Generally, the coupon rate will be the average of rates suggested by two investment banking firms. The new rate will then reflect the level of interest rates at the reset date and the credit spread the market wants on the issue at the reset date.
7 There are bond-only instruments known as CBOs, and loan-only instruments known as CLOs.
8 On the regulatory side, the SEC should complete the registration within 20 days after accepting the application; however, it is not an easy procedure in practice.
9 The issue of securities in China’s securities market has always been nebulous, and it is thought that the “registration system” is better than the “review/approval system”. In fact, just as CSRC chairman-Guo Shuqing put it: “there is no difference between the registration system and approval system.” While the approval system is widely criticized in the industry, two important non-institutional factors are ignored— a number of professional experts in the SEC and accumulated professional experience in the long-term development of the market.
10 In the 1990s, corporate bonds rated below the investment grade accounted for 22 -30% (excluding the year 1998, in which this percentage reached 38%), in 2007, non-investment bond comprised 49% of the market.
