May 3, 2016

In recent years the popularity of ‘high yield lite’ bonds has grown considerably. While relatively unused in Europe in the years immediately following the financial crisis[1] they now account for over a third of new issuances. These bonds lack many of the traditional covenants found in high yield bonds and have a lower recovery rate, putting the bondholder at greater risk in the event of default. The rise in popularity comes as no surprise; low interest rates have left investors desperate for returns while companies are finding it increasingly difficult to access traditional credit facilities. However, it is argued that high yield lite bonds sway too far in the bond issuers’ favour by removing several important restrictions on indebtedness and restricted payments. There are fears that this has led to a ‘Covenant Bubble’ posing a risk not only to the markets, but to the wider society. Pension funds have previously taken a hit during bond market instability leaving many of us exposed to losses. Furthermore, low rated companies will find it increasingly harder to secure funding. With a steadily increasing default rate, there are questions about what this kind of risky investment could pose for the future and wider society.

Covenants are restrictions within the trust indenture[2] that protect the bondholders’ interest by imposing restrictions that prevent the bond issuer from carrying out certain actions that could affect their ability to repay. As subordinated debt, high yield bondholders will only be repaid once all senior debt is settled, provided there is cash remaining. Thus the covenants contained in the indenture will aim to preserve the pool of capital available upon default and prevent further subordination. High yield lite bonds, on the other hand, omit these important covenants as investors sacrifice protection in return for a higher return.

What are the risks to the investor?

To ensure there is enough money left to pay the bondholder, covenants which impose a limitation on indebtedness prevent the issuer from overleveraging (borrowing too much money), while those that place limits on restricted payments[3] prevent the leakage of value through affiliate or subsidiary transactions. The covenants, naturally, have carve-outs and baskets[4] , and their ‘occurrence’ rather than ‘maintenance’ nature means the issuer has the flexibility to run their day to day operations. By omitting these covenants and others like it, the high yield lite bond issuer is free - whether recklessly or fraudulently- to take on additional senior and unserviceable debt, make payments to affiliates, and sell off assets. This not only depletes the capital reserves, reducing the chances of recovery, but could actually be the driving force behind the default. The bondholder may quickly find himself holding a bond for a company he probably wouldn’t have invested in in the first place.

Covenants protecting the issuers’ reserves will protect the bondholder to an extent, but it is equally important to protect against subordination. Subordination refers to the order of claims in the event of bankruptcy or default; it can be affected structurally by granting a lien[5] over an asset. As senior debt, liens receive priority over high yield bonds when it comes to repayment. Commonly found in traditional high yield bonds, the restriction on granting liens and anti-layering covenants protect the bondholders ‘place in the queue’ for recovery. Without these covenants, the issuer is able to give other creditors the legal right to property or acquire debt more senior to the lite bonds. The fact that the low or unrated issuer is in a position they need acquire more debt suggests troubled waters while the investor is left without a life jacket.

Removing even just one of the covenants may leave the bondholder powerless against the issuer. Any attempt at preserving the capital is neutralized if the issuer is just able to push the bondholder further to the back of the line.

What are the risks to the market?

Market participants should be concerned about the future of high yield lite bonds, given recent Covenant Quality (CQ) scores and high yield bond default rates. CQ is a market average recorded by Moody’s and a higher score effectively indicates relatively unrestricted covenants, offering little in the way of investor protection. The recent upward trend is evidence of both the increasing number of high yield lite issuances (which automatically receive the maximum score) and the overall deterioration of investor protection within the high yield bond market. While the market is fairly stable at the moment, we are already seeing danger signs as default rates are on the increase. Moody’s have recently reported that, following the slump in commodity prices at the end of last year, they expect the high yield default rates to break 4% in 2016, up from 1.7% in  April 2014[6]. While not cause for immediate concern, the high yield bond market has historically been extremely volatile and, as default rates rise, perhaps driven by a tightening in monetary policy, market liquidity will drop making it difficult for investors to close out on their exposed holdings. The combination of higher CQ scores and increasing high yield default rates ought to be setting alarm bells ringing, even if the threat is not yet imminent.

Investors should be cautious when investing in high yield lite bonds; although the rates may be attractive now they need to ensure that they have sufficient covenant protection to ensure both recovery in the event of default and to prevent the issuer from operating in a reckless manner. Until investors start insisting on proper covenant protection, we can expect the CQ scores to continue to rise. For many in the industry, it is not a question of if the bubble will burst but when.  In the interim, as the market share of high yield lite issuances continues to rise, so too does the risk and severity of consequences we would have to face in the event of mass default.

[1] https://www.lw.com/thoughtLeadership/covenant-lite-terms-in-europe

[2] The trust indenture is a legally binding contract used between parties to a debt obligation.

[3] A ‘restricted payment’ is any payment (either cash, securities and assets) prohibited by the indenture. They generally include distributions to shareholders such as dividends or the repurchase of shares, as well as investments outside the issuing group.

[4] A ‘carve-out’ is an exception which effectively serves to remove a part of the restriction from the contract. On the other hand, a ‘basket’ is a right to deviate from the restrictions of the contract in certain, well defined circumstances.

[5] A lien is a security interest that is granted over property to ensure the performance of the contract. In the event of default, the holder of the lien has the right to sell the property in order to repay the debt.

[6] http://blogs.barrons.com/incomeinvesting/2014/04/15/junk-bond-default-rate-at-1-7-lowest-since-2008-moodys/