The Incredible Shrinking Bond Covenant
The contracts meant to safeguard high-yield bond investors are becoming less about protection and more about manipulating the system.
With fixed-income investors frantic for every basis point of yield, who has time to read the fine print? No one, junk bond issuers and their lawyers increasingly conclude. Paperwork for investment-grade bonds is generally minimal, reflecting the market’s trust in the borrower. But high-yield covenants have typically come with voluminous restrictions meant to ensure issuers keep enough cash on hand to repay, as well as limit their access to other debt.
In today’s seller’s market, borrowers are watering these contracts down with impunity even as interest-rate spreads compress. Moody’s Covenant Quality Index neared a record low in August, the last month in the books. Junk backed by private-equity houses, which traditionally push the borrowing envelope, enjoyed the weakest protections since the credit agency launched the benchmark in 2011. That’s not to mention the raft of “high-yield lite” bonds that dispense with junk protections altogether, passing as investment grade for legal purposes. These accounted for 40 percent of the U.S. high-yield market in August, with beneficiaries ranging from company-of-the-future Tesla to struggling Rust Belt icon U.S. Steel Corp.
Asset managers may literally not have time to unearth the loopholes and fudges that issuers bury within weighty bond prospectuses, says Evan Friedman, Moody’s head of covenant research. “Some of these issues go the same day they are announced,” he says. “A week would be an eternity.”
One champion is fighting back for investors, though: New York-based Covenant Review, a group of former sell-side attorneys who help buyers get wise to their old colleagues’ tricks. “Our job used to be to put this stuff into documents,” says Anthony Canale, a veteran of white-shoe Wall Street firm Latham & Watkins who now heads Covenant Review’s research. “Now we alert the buy side.”
One focus of Covenant Review’s vigilance is so-called restricted payments provisions, which are supposed to keep the assets and cash flow that secure a bond or loan within the legal entity that issued it. Creatively tweaking these clauses can enable borrowers to “pull a J. Crew,” as covenant nerds now call it – referring to the distressed clothing retailer partially owned by private equity giant TPG, which shuffled valuable trademarks and other assets between subsidiaries before turning to creditors for a debt renegotiation.
Restricted payments covenants are also intended to restrain borrowers’ future leverage, the rule of thumb being that payments cannot exceed 50 percent of consolidated net income. Issuers are proactively bending this stricture too, carving out spurious exceptions for investments that may or may not add to the earnings base, Friedman says. “The environment is as permissive as ever before in allowing for incremental leverage,” he says.
That’s not all. The sell side is also eroding lien agreements that prevent borrowers from subsequently issuing more senior debt, Canale explains. This practice already harmed bondholders in the wave of energy bankruptcies that followed the 2014 crash in oil prices. “When they went back to the documents for some of these issuers, the liens covenant turned out to be worthless,” he says. “So the companies could coerce bondholders to take a haircut if they wanted to get in line in front of the other guys.”
Major bond investors who resist covenant corrosion can win the occasional skirmish, Canale says. A Covenant Review alert in July forced Vivint, a Nasdaq-listed smart home tech provider owned by private equity giant Blackstone Group, to ax provisions that would have allowed the company to be sold without buying back its bonds and paying holders foregone interest income, a protection known as making investors “whole.” But insurance brokerage AssuredPartners managed to market its bond issue days later despite similar objections, Canale admits, and there are no signs of the larger tide turning in investors’ favor. “Every week we see new innovations from the sponsor side,” he says. “Each document is like a tailored suit with its own pockets to manipulate the capital structure.”
In theory, borrowers should pay higher interest for bonds with weaker repayment protections. But apparently no one told the market that. Moody’s credit quality measure has slid steadily this year, while high-yield bond spreads over treasuries hover at post-2008 lows around 3.5 percent, according to Bank of America Merrill Lynch data.
Investors do have their reasons to be permissive. Junk default rates have confounded bearish predictions for most of this decade, hewing close to a historically low 2 percent. If 98 percent of bonds pay as promised, there is limited incentive to haggle over contractual minutiae. But issuer sleight of hand and bullying, particularly by the private equity powerhouses, also plays its part, Friedman says. “I can unequivocally say that private equity investors are more aggressive,” he observes. “They use their negotiating leverage, relationships, and awareness to ask for things that other issuers don’t get.”
The cure for watered down bond provisions may be worse than the disease, Friedman adds. “Barring some larger macroeconomic event, we don’t foresee quality returning to 2011 to 2012 levels,” he says. “Run-of-the-mill economics will not bring it back.”