Fitch says speculative-grade emerging market bond covenants fall short

By Angela McDaniels

Tacoma, Wash., June 12 - Fitch Ratings said covenant packages for speculative-grade emerging market corporate bonds issued in recent years have been weakly structured, as covenants needed to protect bondholders from negative credit migration and event risk have typically not been included.

An agency report found that covenant limitations have been lax, with significant carve outs, enabling issuers to increase financial leverage - particularly debt ranking ahead of unsecured bonds - causing higher structural subordination risk.

Furthermore, the agency said the credit crisis that took root in 2007 has highlighted some new shortcomings in speculative-grade covenants, for example, the lack of limitation on hedging obligations.

Maintenance vs. incurrence based

Fitch believes that speculative-grade emerging market bondholders would be better placed to protect their credit exposures at times of issuer financial stress if they benefited from maintenance-based covenants.

"The problem with incurrence-based covenants is that they are only effective, for example, when an issuer wants to raise additional debt," Siew-Huey Loong, director with the agency's Asia Pacific corporates ratings group, said in a news release.

"Therefore, while lenders with maintenance-based covenants are able to enter into negotiations with the borrowers at an early stage given regular monitoring of credit metrics, bondholders with incurrence-based covenants do not enjoy the same protection."

Ratings impact

Fitch noted in the report that compared to covenants in structured finance obligations, covenants in corporate bonds typically have almost no impact on the ratings of the issuer or the specific debt instrument because they are designed to address event and migration risks that are not captured in the ratings.

Covenants typically are meant to give investors more leverage if events that might be detrimental to the credit profile occur rather than prevent those events from occurring in the first place, the agency said.

Restructurings

Fitch said one of its findings is that some issuers that have gone through restructurings in a previous crisis have been subject to more stringent structures and covenants when they subsequently issued bonds.

"However, even these bond structures and covenants may become watered down and ineffective in a cheap credit environment," Raymond Hill, senior director in Fitch's EMEA/emerging markets corporate ratings group, said in the release.

"The relative strength of bondholders to negotiate the inclusion and the nature of covenant packages in restructurings will depend on the individual circumstances of each situation. In some cases observed by Fitch, the bondholders' position relative to secured creditors was so disadvantaged they had only a limited influence in negotiating a restructuring."

New problems

In addition, Fitch pointed out that during the current credit crisis, new problems have emerged relating to covenants. For example, the Latin America bond markets have experienced a significant increase in debt defaults during the second half of 2008. In some cases, the defaults have been attributable to foreign-exchange losses associated with derivatives contracts.

"The limitation on hedging obligations clause has turned out to be lacking, as issuers have ventured into speculative directional hedging," Jose Vertiz, director in Fitch's Latin America corporate ratings group, said in the release.

"The emergence of new problems with covenants, and the re-emergence of old problems with restructured covenants, serves to emphasize the importance of closely analyzing non-investment grade covenants and of investors ensuring that they are adequately protected at the time of issuance. It is imperative that bond investors are fully aware of these issues when the credit cycle turns."

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