Emerging Market Covenant Quality Reaches All-time Weakest Level Amid Slowing Issuance

Monday, October 05, 2020 10:16 AM /by  Moody's Investors Service/ Header Image Credit:  Investors Diurnal Finance Magazine

• The average covenant quality (CQ) score worsened 6% to 3.45 (weak) in the six months to 30 September 2020, with a higher score denoting weaker covenant quality
• Scores weakened in five of the six areas monitored by Moody's, with only liens subordination scores strengthening

Moody's Investors Service says in a new report that the quality of covenants in full-package emerging market (EM) bonds has dropped significantly over the past six months, with in particular cash leakage and risky investments scores continuing to weaken.

Still, EM covenant quality remains considerably stronger than in North America and EMEA, with EM bonds having stronger scores in five of the six key risk areas.

"The weaker scores in particular for cash leakage and risky investments can be attributed to repeat Chinese property issuers that predate their restricted payments income baskets to coincide with those of their previous bonds," says Jake Avayou, a Moody's Vice President and Senior Covenant Officer.

In addition, average permitted investments carve-outs for EM bonds issued during the period increased to 23% of total assets, compared with 18% for the six months ended 31 March 2020.

Chinese property developers typically negotiate large permitted investments carve-outs that enable them to invest in or enter into joint ventures with entities outside of the restricted group.

"Still, EM bonds compare strongly to North America and EMEA bonds, with weaker scores only on structural subordination, which remains a key concern for Chinese bonds," adds Avayou.

Asian companies continued to dominate EM bond issuance, accounting for 82% of issuance, followed by Latin America at 15%, and Africa and the Middle East at 3%. There were no bonds from Emerging Europe in the six months ended 30 September 2020.

Moody's CQ score combines six factors: (1) cash leakage, (2) risky investments, (3) leveraging, (4) liens subordination, (5) structural subordination and (6) change of control.

The average CQ score for EM bonds issued over the past six months is now at the weakest level since Moody's published its first EM covenants report in September 2018, and is also much weaker than the average 2.95 (moderate) CQ score for the period from January 2011 through 30 September 2020.

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