Ahead of the curve: Why bond covenants matter
For bond investors, who lack a shareholder vote, covenants are the G (or corporate governance) in ESG. Covenants form the legal rights for bondholders to protect and ensure that a company’s cash flow is targeted towards the interest payments (coupons), and the redemption of its bonds.
Covenant quality is closely related to the market cycle and it is possible to pinpoint the stage in the cycle by following the trend of covenants. Low default rates, tight spreads, rising and high leverage, and longer bond maturities – are clues that we are in a late cycle stage. At this point, investors become impatient in their search for yield, and power begins to shift towards issuers, who start relaxing covenants.
Covenant packages have been deteriorating for some time. Moody’s index of covenant quality recently measured close to its worst reading ever, even as coupons – which are intended to compensate for risk – have continued to fall.
It is crucial for investors to know how covenants, which are designed to protect against risky behaviour, are changing so that they are aware of the risks they are taking. A combined approach of picking the bonds with the strongest fundamentals, and understanding covenants, will place investors in the best position as this cycle matures.
While the balance of power in covenant agreements swings towards issuers, investors can protect themselves.
Bond offering memoranda can run into hundreds of pages and are filled with legalese. These documents establish the legal rights for bondholders and investors need to be clear on how they will be treated under different scenarios, and their avenues of recourse.
It is important to pay close attention to a company’s limitation on indebtedness, particularly which corporate assets are provided as security for bondholders, and whether companies can incur indebtedness at operating companies to structurally subordinate the bonds.
This work requires skilled, experienced and dedicated legal resources who can understand, interpret and communicate the technical language in the documents.
No one individual is going to be able to master all the diverse skills required to effectively invest in bonds throughout the market cycle. It needs teams working across divisions who can interact seamlessly.
Credit analysts are central but they need access to expert legal opinions, and the opportunity to work with equity analysts to build a more comprehensive understanding of a company. Portfolio managers have to lean on all these skillsets, sometimes at short notice, to make informed decisions under pressure.
It is often necessary to engage issuers and push back on terms. This is not easy, and requires credibility with the issuer and the capacity to engage in resource-intensive negotiations. Investors must commit to time-consuming discussions, and be strategic with the issuers.
Investors must also engage with other investors to discover mutual interest and combine efforts effectively. Investors can participate in industry groups and standards boards, and by liaising with market regulators it is possible to promote bondholder interests and establish a strong voice.
One good example is the recent Diversey high-yield bond issuance. Several investors across the buyside pushed back against the inclusion of a permitted investment basket that created a potentially unlimited capacity to make investments outside the credit group. The result was the removal of the offending permitted investment basket from the final documentation.
There are times when investors are unable to convince issuers to remove egregious terms. In these situations, the only option is to refrain from investment, either entirely or to wait until the price declines to a point where the yield is high enough to compensate for the risk created by the loose covenant package.
A case in point is the recent HEMA bond issue. Fidelity International chose to refrain from investing in HEMA for several reasons including the flexibility granted to the company to calculate its financial ratios and the lack of transparency in how those calculations are made.
Bond covenants are an essential line of defence for credit investors. The gradual erosion in their standards not only signals the maturity of the cycle, but also indicates that investors need to adapt their approach to bonds.
Much of the trend in watered-down bond covenants is being driven by private equity, which has large pools of capital deployed in the market. Dry powder (uninvested capital) is approaching $1trn (€830m) the highest it has ever been.1 As this money starts entering the market, covenants could weaken even further.
Despite the pressures on covenant quality there are still opportunities in the bond market but these require more due diligence and discretion. More than ever, fundamental analysis should be complemented with a thorough review of covenant agreements to target adequate returns without overly compromising investor protection.
Martin Dropkin is the head of fixed income research at Fidelity International