A bond by any other name would smell as sweet, but the incorporation of various credit enhancements could just make that bond smell even sweeter to the bondholder. Investors should note the presence of various credit enhancements which could provide an additional layer of security to the holder of the bond.
Debt covenants
Debt covenants are common credit enhancement features which do not require the company to secure the assistance of an external party. Covenants are promises or agreements (the use of the word dates back to biblical times!) involving one’s conduct. In the context of bonds, debt covenants are promises made by the issuer not to engage in certain actions which could be to the detriment of the bondholder. If such covenants are breached, this may be tantamount to a default, and the bondholder may have the right to demand full repayment. Debt covenants can cover a wide range of parameters, although common debt covenants tend to cover limits on debt ratios, which can limit the amount of additional debt which can be issued. Covenants can also cover parameters like liquidity or working capital, which “force” an issuer to be prudent in its capital management.
Guarantees
Sometimes, a financially-weaker bond issuer may rely on the strength of its parent to provide an explicit guarantee for its subsidiary’s debt. Having a guarantee from a more creditworthy guarantor is a significant credit enhancement for the bond, since the guarantee is legally enforceable. In such instances, the subsidiary’s bonds may be viewed as being “credit-enhanced” to the extent that it may be rated in a similar fashion to that of the more creditworthy parent.
Keepwell Agreements
Keepwell agreements can sometimes be drafted as a form of credit enhancement for a bond – this is usually an agreement between the parent company and the subsidiary (which is the issuer), where the parent agrees keep the issuing subsidiary in good financial healthy, by maintaining certain financial ratios or levels of equity. Unlike a guarantee, keepwell agreements are not legally binding, and the way such agreements are drafted can make them similar to a parent guarantee (if the terms of the agreement are sufficiently stringent, and allow bondholders sufficient recourse to the parent in the event of a failure to meet those conditions), or simply having perfunctory or superficial enhancement qualities for the particular bond (in the case where the terms of the keepwell agreement are loosely drafted, like in the case of a “letter of support”, which allows investors minimal recourse to the issuer’s parent).
Bank guarantee or letter of credit
Keepwell agreements or a letter of support can be enhanced by the inclusion of a bank guarantee or letter of credit. This additional support by the bank comes at an additional cost to the issuer, but significantly enhances the credit quality of the bond, since bondholders can now look towards the bank for legal recourse in the event that the issuer defaults.
The Research Team is part of iFAST Financial Pte Ltd.