Joseph Mariathasan and Martin Steward ask whether investors’ traditional protections are getting squeezed out in the convergence of high yield bond and loan markets

Investing in debt always represents a trade-off between the interests of the investor and those of the issuer. Who has more power is a function of supply and demand. Over the past few years, investors in their search for yield have driven up demand, so the response by issuers has been a reduction in covenant terms and ever shortening non-call periods on newly issued high-yield bonds. 

In Europe, the lowering of covenant and call protection has occurred in a period when leveraged loan issuers have been refinancing themselves in the high-yield bond market, giving rise to some convergence in terms and structure between the two. More senior-secured has been issued than usual as a result of this trend, for example, where call protection has been eroded in return for greater security. Shortening call periods are an issue for investors if a bond is upgraded or there is some other positive event.

“This has changed the dynamics of how people look at high-yield,” says Garland Hansmann, portfolio manager at Intermediate Capital Group (ICG). Whether the increased security will be of great benefit in later restructurings remains to be seen but, as Hansmann adds, there are still deals that come with very good call protection for more selective investors. 

Furthermore, as Marianne Rossi, lead portfolio manager for US high-yield at Stone Harbor Investment Partners, points out, with financing rates where they are today, it is difficult to imagine issuers calling bonds to refinance at lower rates five years from now. “However, we think the real issue is that if there is a positive event and the bonds become callable, investors lose out on some of the upside they would have anticipated,” she adds.

“The demand for short-duration high-yield in Europe has led to a lot of issuance of short-dated bonds with one or two-year non-call periods,” says Mitch Reznick, co-head of credit at Hermes Fund Managers. “The problem with such short maturities and call periods is as a high-yield investor you give away so much of the equity-like upside. That makes it somewhat more difficult to buy the bond, even if you like the company.  

“An elegant way around that is for companies that want to issue short-dated/short call securities to offer either bonds with an OID [original issue discount], perhaps issuing at 98 or 99 instead of par – which is traditional with PIK notes, and which we saw with Johnston Press done by JPMorgan; or if the first call is a couple of years away, then give us full coupon at first call instead of half.”

On the loans side, covenants have become very slack in the US market. Cathy Nolan, lead US loan portfolio manager at Stone Harbor Investment Partners, estimates that 60-65% of US loans fall into the ‘cov-lite’ category. “Generally the two financial covenants are debt/EBITDA ratios and interest coverage, with the former being more meaningful,” she explains. “That restriction has been eliminated in cov-lite structures.” 

As long as there are seven or eight years left until the maturity of the debt and a struggling borrower can meet its interest coverage, it can take advantage of that time to put off default as it tries to turn things around. That can, of course, help avoid default, but it also means that the borrower’s equity owners are not under much pressure really to consider lenders’ position until much closer to that maturity date.  

“At times, you can get ‘zombie’ companies where the debt multiples may be way outside the enterprise valuations but the owners will cling on and hope that they can turn the business round without lender interference,” explains Jonathan Butler, head of leveraged finance in Europe for Pramerica.  

The loan-covenant picture in Europe is more mixed but, in general, protection has been reduced from four or five covenants to one or two on new deals. The one that is always there is on the net debt-to-EBITDA ratio. The next most popular is the cashflow covenant, and the restrictions on capex covenant is the one that tends to get dropped at the earliest opportunity.

“That works for us quite well because when a credit gets into trouble, the first covenant they trip is the net debt/EBITDA coverage ratio,” as Hansmann observes. “The main function of a covenant is that when a [borrower] gets into difficult times, you want to be able to force the company into a conversation with you – and that still remains very much the case, even if you have one or two covenants less. The others, while interesting, were never the ones that you had to use when the going got tough.” 

Elissa Johnson, director of loans at Henderson Global investors, adds that covenants can be more important when lending to cyclical companies, providing investors with excess-return opportunities when debt terms are renegotiated following a breach. 

“During the 2008 crisis, we had a lot of opportunities to reprice debt or get equity because companies were breaching covenants,” she says. “The companies came back to health in 2010 and if it had not been for the covenant structures, we would not have been able to take advantage of that.” 

Indeed, Johnson says she is very comfortable with the trend to cov-lite because the extra resulting volatility it generates provides opportunities to outperform peers. 

In any case, trends in investor protection should always be considered in the light of the recovery from the post-crisis recession: whereas trailing yearly defaults in US high-yield hit 14% in July 2009, the  figure for January 2014 was just 2%. 

“Most people anticipate that default rates will stay low for the next couple of years and there is nothing in the aggregate economic figures coming out that would make you [doubt that],” says Rossi, who emphasises that the changing nature of covenant protection in the loan market has been a function of supply and demand, not of changing credit quality. 

“Any deal coming into the market now with stronger covenants almost, by definition, must be of lesser credit quality. There has been a lot of research on the default and recovery rates of covenant-lite structures versus fully covenanted, which shows that issues done with strong financial covenants have been of lower credit quality than those with covenant-lite structures.” 

Nolan agrees, saying that there has probably been undue emphasis on covenants, as opposed to credit quality, in the media. 

“You will never see a good covenant package turn a poor credit into a good one,” she insists. “In the loan market, if covenants are the prime criteria on which to base investment decisions, your portfolio will be exposed to adverse credit selection because it is the lower credits in the loan market that are required in this market to borrow money with financial maintenance covenants.”