The objective of this article is to answer the following questions about the Chilean corporate bond market: What drives bondholders to accept management’s proposal of covenant changes and waiver requests on certain occasions and reject them on other ones? Is it a decision-making process based on cost-benefit analysis? Does it have to do with the proposed compensation and the history of the management? And if so, how much do companies pay in fees for these events?
I expect institutional investors, bookrunners and issuers of corporate bonds to be benefited by this article.
Rejections are not unusual, although it is more common that investors accept covenant changes or grant waivers to bond issuers. My perspective is that investors give importance mainly to the compensation offered and management’s history, where I believe trust is key in covenant renegotiations.
The most popular form of compensation is the flat fee type, found in 53% of the cases in my study, with an average payment of 53 bps over the issuer’s debt outstanding. Note that 88% of the 59 sample cases included some form of compensation for the covenant changes or waiver requests in Chile from 2003 to 2016.
Introduction to the Chilean Corporate Bond Market
As presented in Figure 1, the Chilean non-banking corporate bond market represented 12.5% of the country’s GDP as of June 30, 2018, and the placements averaged US$5.4 billion per year in the 2010-2018 period, according to the Banco Central de Chile. The issuances are usually inflation-linked and denominated in Unidades de Fomento (UF)*, in line with the indexation of many contracts in the Chilean economy (e.g., healthcare, insurance, etc.), with 92.8% of the debt outstanding, as of October 2018. There are also nominal issuances in CLP and in US$, but these are less frequent, as presented in Figure 2. Additionally, the bonds’ indentures usually incorporate covenants.
*The UF (ISO 4217: CLF) is a unit of account linked to inflation that is used in Chile.
Figure 1. Chilean Corporate Bond Market.
As presented in Figure 3, the main local institutional investors in Chilean corporate bonds are pension funds (43.5% of the debt outstanding as of September 30, 2018), insurance companies (39.3%) and mutual & investment funds (10.4%); other local investors represent 6.8%.
Figure 2. Corporate Bonds by Currency.
Source: Banco Central de Chile.
Figure 3. Corporate Bonds Held by Local Investors.
Source: Banco Central de Chile.
Renegotiations: “To Waiver or Not to Waiver”
There are different reasons why corporate issuers may need to renegotiation covenants or request a waiver. Examples of these reasons include the following.
- Corporate actions: In 2016, after the split of Gasco to Gasco GLP and Gasco GN, the holders of B, D, F1, F2 and H bond lines approved the change to two financial covenants and to eliminate the payment solidarity between the companies post-split.
- Modernize financial ratios: In 2015, the series A bondholders of Nuevosur approved changes to two financial covenants, including to swap the liabilities/equity ratio for the net debt/EBITDA ratio.
- Prevent a covenant breach: In 2015, the series A and C bondholders of Red Salud granted an 18-month waiver related to the net financial expenses financial ratio.
- Request of a waiver after a covenant breach: In 2013, the bondholders granted a waiver to bonds series A/C, A, B and D of SMU suspending the enforceability of two financial covenants.
- Chilean GAAP to IFRS shift: Finally, several companies needed to change their covenants in 2009-2010 when Chile switched from GAAP to IFRS, considering that Chilean GAAP formerly required individual financial statements while IFRS requires consolidated financial statements.
In this context, investors need to balance the costs and benefits of “to waiver or not to waiver.” The cost-benefit analysis from the cost side, conducted by investors, includes the following.
- Issuer’s illiquidity: The cost of rejecting a covenant renegotiation is that in the event of rejection, the issuer may need to accelerate the payments of debt outstanding plus the accrued interests. Does the company have sufficient liquidity to pay its debt outstanding? Here, the credit analysis done by the investors with respect to the issuer’s debt capacity is vital.
- Other investment options: Does the investor have equivalent investment options? Here, it is important to constantly monitor the market to evaluate alternative investment options for the different risk exposures such as duration, rating, yields, currency and liquidity in the secondary market.
- Loss of confidence: If management knows beforehand that bondholders will approve their proposals, then an incentives problem can be generated in the future, with the investor consequently losing confidence in the management’s quality and credibility—the classic agent-principal problem.
The cost-benefit analysis from the benefit side, conducted by investors, includes the following.
- Compensation: If investors approve the renegotiation, they may be entitled to a fee payment from the issuer as a form of compensation.
- Initial conditions: Some of the changes requested by companies can be so significant that the bondholder does not approve them given that the core business to which he or she was exposed is materially changing.
- Aligned incentives: If management knows beforehand that bondholders will not approve their proposals or that they will at least need negotiations, then the incentives between the agent and principal will remain aligned and initial covenants will remain in compliance.
Finally, one additional benefit is that covenant renegotiations are key to the normal functioning of debt markets, as Roberts (2015) concludes.
Racconto of Compensations
In Chile, there have been different forms of compensation, such as:
- Flat fee: In this case, there is a flat payment of the debt outstanding that the investor holds in his or her possession. The minimum and maximum range that the Chilean market has seen has been relatively wide, with payments as low as 10 bps and as high as 100 bps over the outstanding.
- Flat fee/duration: In this case, there is a payment that increases per year of duration or in tranches (e.g., 20 bps per year of duration).
- Flat fee/outstanding: In this case, there is a fixed payment (in UF or in CLP) for each tranche of debt outstanding (e.g., UF50 for each UF5,000).
As presented in Figures 4 and 5, based on a sample of 59 completed covenant changes and/or waivers in more than 25 companies that issued corporate bonds between 2003 and 2016, the most common form of compensation for bondholders was flat fee (53%), followed by flat fee/duration (29%); meanwhile the flat fee/outstanding type accounted for 5%. On the other hand, 12% did not include any form of compensation.
- Flat fee: The median fee was 50 bps while the average fee was 53 bps.
- Flat fee/duration: The median fee was 20 bps per year of duration while the average was 24 bps per year of duration.
- Flat fee/outstanding: The median fee was 82 bps while the average was 129 bps; in this case, the data was calculated over the ceiling of the range (e.g., UF50/UF5,000).
Figure 4. Renegotiation Fees.
Source: Author database.
Figure 5. Renegotiation Fees.
Source: Author database.
Management’s History: Trust Is Key in Covenant Renegotiations
Trust is not only a key part in contracts but also in business success and economic prosperity, or what Fukuyama (1995) calls “spontaneous sociability.” A company’s character is one of the four C’s in credit analysis, along with covenants, capacity and collateral, according to Fabozzi (2007). In this context, success in bond renegotiations is subject to trust between the management and investors based on management’s history. In Chile, trust is an even more important part of successful bond renegotiations and waiver requests mainly due to the following.
- A relatively small market: Chile’s weight in the MSCI EM LatAm Index was 9.2%, as of November 30, 2018.
- Geographically centralized financial market: As presented in Figure 6, 90% of pension funds and insurers’ headquarters are based in Las Condes, Providencia and Santiago—all sectors of the city of Santiago—while 100% of both the top 5 Chilean bonds’ bookrunners and the top 10 largest non-banking corporates in the Chilean equity index, S&P/CLX IPSA, are based in those same three sectors.
Figure 6. Map of Pension Funds, Insurers, Bookrunners and Non-Banking Corporates.
Source: Comisión para el Mercado Financiero Chile, Google Maps. Red markers represent the headquarter addresses of pension funds, insurers, top 5 Chilean bonds’ bookrunners and the top 10 largest non-banking corporates in the Chilean equity index S&P/CLX IPSA. Map excludes one insurer based in Valparaiso for illustrative purposes.
All in all, the key takeaways of my article are the following.
- Drivers for accepting or rejecting covenant changes or granting waivers to issuers: According to my perspective, the compensation offered and the management’s history are the most important factors. Additionally, topics such as the liquidity of the issuer and alternative opportunities for investments should be considered.
- Compensation offered: I found that the most popular form of compensation is the flat fee type—found in 53% of the cases—with an average payment of 53 bps over the issuer´s debt outstanding.
- Management’s history: As the Chilean market is relatively small and very centralized to Santiago, the trust relationship between bondholders and the senior management of issuers is relevant at the time of renegotiations.
- Banco Central de Chile, 2018, Informe de Estabilidad Financiera Primer Semestre and Segundo Semestre.
- Braun. M., Briones. I., 2008, The Development of the Chilean Corporate Bond Market.
- Comisión para el Mercado Financiero Chile.
- Fabozzi, F.J., 2007, Fixed Income Analysis.
- Fukuyama, F., 1995, Trust: The Social Virtues and the Creation of Prosperity.
- International Monetary Fund, October 2018, World Economic Outlook.
- Roberts M., 2015, The role of dynamic renegotiation and asymmetric information in financial contracting, Journal of Financial Economics 116, p. 61-81.
- Superintendencia de Bancos e Instituciones Financieras Chile.
- World Economic Forum, 2018, The Global Competitiveness Report.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.