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Capital Markets

Weakening Covenants for Junk Bonds Pose Risk

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March 09, 2018

Moody’s says weak covenants were on the rise in 2017 and could imperil investors in a downturn

Fri Currency in Gears SmallStrict bond covenants have become a nostalgic thing of the past as more and more lenders are offering easier terms to even the riskiest of companies. According to Moody’s Investors Service, the average covenant quality (CQ) score for bonds issued in 2017 was 4.36 (weakest), which is the fourth consecutive year with a weakest-level average CQ score. This is on a scale of 1-5, with 5 being the weakest.

This could put investors in a sticky situation in a downturn, Moody’s says, because holders of covenant-light bonds will have little control of the issuer’s actions to mitigate its losses. In fact, bondholder rights will be secondary to shareholders should a downturn happen.

“[I]f speculative-grade companies were to come under pressure during a turn in the credit cycle, the lax covenants in their bond indentures would allow them to take a host of shareholder-friendly measures without consulting or compensating their bondholders,” Moody’s says in a report. “These measures include the sale and transfer of assets outside of a restricted group, refinancing earlier maturing unsecured debt with secured debt, and expanding into new and uncertain lines of business.”

And since highly leveraged companies will struggle under new tax laws (see related story here), there could be more stresses and defaults in the future.

While experts say those buying the debt should make sure their analysis is sound, sometimes they are not getting the time. According to Moody’s demand is so strong that many bond issues are oversubscribed resulting in very short roadshows. This gives investors “limited time to review deal terms … diminishing their ability to challenge covenant structures.” Meanwhile, with credit conditions positive and holding steady across the spectrum, “including a speculative grade default rate that we expect will continue to rest below its historical average,” investors have been more willing to abide deteriorating credit protections within bond contracts, Moody’s says.

All of this adds more risk to the market. Ordinarily, covenants maintain a balance between an issuer’s fiduciary obligations to its shareholders and its contractual obligations to creditors. However, increasingly, “covenants are not achieving that objective,” Moody’s says. And investors searching for yield anywhere they can, are becoming more and more lax, “willing to give spec-grade issuers the operational flexibility once reserved only for investment grade credits because of their strong financial profiles.” And if a downturn comes, investors in high-yield covenant-lite bonds “will be powerless to prevent issuers from taking actions that favor their shareholders at bondholder expense.”

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