Date: February 4, 2021
In our previous articles in this series, we have talked about how bonds can fit into an investor’s portfolio, their main features and risks as well as the documents that should read.
Of the many risks which could affect bond investors, default risk is a key risk. In simple terms, it is the likelihood that the issuer cannot meet its obligations.
What constitutes a default?
A default is the issuer’s failure to pay interest or principal on the payment due date. However, note that if the issuer fails to observe certain specified financial covenants, such as ensuring that the net borrowings to total equity does not exceed a certain threshold, this could also constitute an “event of default”. Such covenants will be mentioned in the offer document, so be sure to read and understand them.
All offer documents will contain information on the relevant events that could constitute a default.
How can an investor spot the signs of a default?
There are many different reasons that can lead to a default and affect the restructuring and repayment process. For instance, the oil and gas (O&G) sector was badly hit by the prolonged slump in oil prices from 2014 onwards and several companies in the sector ran into major financial distress. This in turn led to them defaulting on their debt payments.
In the case of the O&G sector, the underlying cause of the defaults was a largely unforeseen external macroeconomic event, namely an unanticipated plunge in oil prices.
On the other hand, in the high-profile case of Hyflux Ltd, it was its risky expansion into the power generation business that led to its financial woes and defaults.
Some observers believe the company did not pay sufficient attention to the risks when diversifying into a non-core business and overstretched itself financially.
Investors should pay close attention to the factors that could adversely affect the companies they have invested in by closely reading the issuers’ financial statements and regular announcements.
They should also be aware of changes in the external environment such as interest rate shifts that could impact their bonds.
What happen to bondholders when a company defaults?
What bondholders receive after the default — and when they receive it — can vary significantly. There are three possible scenarios:
- Debt restructuring
If an issuer is in financial difficulties and foresees that it may default on its debt payments, it can apply to the Courts for a debt moratorium. This will buy an issuer time to negotiate a debt restructuring.
The aim would be for the issuer to work out a payment plan or arrangement to reduce its debt burden and continue its operations without having to be declared bankrupt.
Typically, this could involve various measures such as reducing the principal amount of the bonds, extending the tenure or exchanging bonds for shares. All these would require the approval of bondholders at meetings convened for this purpose.
The worst-case scenario in this situation would be for the issuer to be placed under judicial management and faced with the threat of winding up. In which case, investors face the very real risk of losing their entire investment.
- Winding up
A company can be wound up either voluntarily or by the Courts. Whichever route is taken, the company ceases its business, assets are sold and whatever cash is recovered is then used to pay its debts.
How much investors receive will then depend on the type or seniority of debt that they hold because payment will be made according to a ranking that was established when the debt was first issued.
In general, secured debt or borrowing that is backed by collateral, is ranked as senior, whilst unsecured debt is junior.
If the bonds held are lowly-ranked or in other words are classified as junior debt, then it is possible that the holder may not receive much or anything at all, depending on how much was raised from the sale of the company’s assets.
- Judicial management or scheme of arrangement
If a company is placed under judicial management either voluntarily or by the Courts, it is protected from creditors’ claims. Judicial management is a method of debt restructuring where an independent judicial manager is appointed to manage the affairs, business and property of a company under financial distress.
This route might be taken by companies that may be temporarily insolvent but have attractive business models that might appeal to potential buyers. In such cases, the company could be put under judicial management to shield it temporarily from third-party creditors whilst it works towards finding a “white knight’’ to buy it over.
The judicial manager must act in the interest of all creditors and is required to report to the Court, which is the source of its appointment.
A scheme of arrangement is similar to judicial management as it is a statutory tool that aims to allow financially distressed companies to be rescued or revived.
However, the key difference between them is that a scheme of arrangement is undertaken by the company’s management, while judicial management is supervised by an external judicial manager.
The assistance that SIAS provides in the event of default
Whatever the cause of the defaults, many affected issuers have turned to SIAS for help over the past 6-7 years. SIAS’s role has evolved over the years and we have now accumulated considerable experience in handling bond defaults, the restructuring negotiations and dealing with Court actions.
SIAS’s involvement can be found in this article but in essence, our priority is to
- try as far as possible, if the issuer has a viable business, ensure it continues as a going concern and to avoid a winding up;
- represent minorities in restructuring negotiations in order to ensure they get the best possible deal;
- act as a moderator in meetings between the issuer’s management and stakeholders, whilst providing on a pro bono basis, independent financial advice.