Covenant Lite Loans and Junk Bonds Raise Fears
Look out: A day or reckoning for junk bonds and junk loans is coming. Many of these borrowings, known as covenant lite, are shorn of traditional investor protections.
Come the next recession, debt holders in highly leveraged corporations may find the bonds and loans issued in good times could wind up in peril. In recent years, there has been a rise of covenant-lite debt, meaning that the restrictions placed on the issuers were pared back or even eliminated altogether.
“When credit quality takes a backseat,” problems will develop as corporate revenue shrinks, noted David Ader, chief macro strategist at Informa Financial Intelligence.
Right now, defaults are low for these loans and bonds. The US historical default rate average for leveraged loans—that is, loans to companies with big debt loads—is 3.1%, and for junk bonds, a notch higher at 4.2%. Once hard times hit, though, the picture gets grimmer. In recession-ridden 2009, the global junk bond default rate was 9.9% with the leveraged loan default rate at almost 11%. When heavy defaults come, it’s like playing whack-a-mole, where problems suddenly crop up for investors used to a placid existence.
Covenant-lite loans and bonds, issued by below-investment-grade companies, pay extra interest—around 0.9 percentage point, by one estimate. That’s on top of the higher yields these speculative instruments generate: 3.7 points over the London Interbank Offered Rate for leveraged loans overall, per the Credit Suisse Leveraged Loan Index; and 3.3 points over 10-year Treasury notes for junk bonds, says Bank of America Merrill Lynch.
What prompted the covenant retreat? “It’s due to low interest rates,” said Josh Freeman, director of fixed income at International Assets Advisory. Rates, while rising gradually these days, are still at relatively low levels, thus investors have been scrambling for better yields. So cov lite instruments, which pay more than covenant-laden leveraged loans and junk bonds, look particularly appetizing.
Some 85% of leveraged loans are cov lite, according to Standard & Poor’s, with the level for junk estimated to be in that neighborhood.
Issuers are happy to peddle these things because they get greater freedom. For instance, a standard loan covenant mandates that the issuer maintain certain financial ratios. If a company doesn’t stick to the rules, debt holders can demand repayment of principal. While that rarely happens, additional penalties would be slapped on the errant issuer. But with cov lite, issuers don’t have to worry as much about such annoyances.
Companies whose financials go through a rough patch welcome the flexibility that cov lite brings, such as giving them more time to rearrange the balance sheet to lessen the debt load or selling off subsidiaries. “The company gets breathing space,” said John Dickie, co-head of US private equity at Aberdeen Standard.
Junk bond issuance used to dwarf that of leveraged loans, yet lately the loans have pulled ahead, with $360 billion issued in 2017, by S&P’s count (see chart), for those with cov lite. That’s versus $283 billion for total high-yield bonds (per the Securities Industry and Financial Markets Association). The exact amount of cov lite junk bonds is not available.
And that’s despite the bonds’ paying more than the loans—6.2% on average, compared to 5.3%, at last measure. The difference is because the loans are a bit less risky, as they are secured by collateral, unlike most junk bonds, and rank higher in the capital structure. That higher ranking means that the odds are better that a lender will be repaid in a bankruptcy proceeding.
For loan buyers, these loans also have the virtue of being floating rate, so they would better keep up with inflation. Another plus, from the banks’ point of view: The loans are packaged into collateralized loan obligations. Joining these pools gets the loans off the banks’ books, letting them record nice profits.
Leveraged loans and junk bonds typically have different types of covenants, and it’s arguable whether the absence of them makes one or the other riskier in cov lite situations.
Loans often have maintenance covenants, which require them to meet regular financial tests, such as keeping a certain debt-to-cash flow ratio. Once these restrictions are yanked, investors run a greater risk of seeing their loan issuers unable to service the debt because the issuers had the liberty to shrug off a more cautious approach to their financing.
Bonds, on the other hand, don’t usually have that protection, but sport two other key covenants—curbing cash drains like stock buybacks or higher dividends, and preventing taking on more debt. Thanks to the cov lite trend, these safeguards frequently are axed for junk paper lately.
The downside of covenants lites is they “allow companies to do things” that strong covenants likely would bar, said Jim Schaeffer, deputy chief investment officer at Aegon Asset Management.
One example he gives is J. Crew, the struggling clothing retailer, which aided its financial position in 2016 with a surprise maneuver that left its lenders flabbergasted. The company offloaded the $250 million in assets it had posted as collateral—trademarks and other intellectual property—by transferring them to a newly created entity that the lenders had no claim to. J. Crew won a court battle, arguing that its skimpy covenant protection permitted it to make the shift.
Another example: Similarly stumbling PetSmart, which sells pets and pet supplies, used much the same tactic, this time involving an online pet retailer it bought last year named Chewy. It could be that this is a bargaining tactic to attract PetSmart junk bondholders into exchanging their paper into equity, which would ease the debt burden.
“Sure, there’s demand for covenant lites,” Informa’s Ader said. “But you shouldn’t mistake demand for meaning that they are OK.”