Strong demand for ‘junk’ bonds erodes investor protection

March 12, 2014 5:07 pm

Strong demand for ‘junk’ bonds erodes investor protection

By Tracy Alloway and Vivianne Rodrigues in New York

Insatiable investor demand for higher yielding securities has helped push protection for buyers of junk-rated bonds to its lowest level on record, the rating agency Moody’s has warned.

The agency’s score of “covenant quality” moved from 3.84 at the start of the year to 4.36 in February, with a score of ‘5’ indicating the weakest possible protection for investors who buy high-yield corporate debt. That is the worst score of junk-rated bond quality since Moody’s began tracking the market in early 2011.

Covenants are a type of investor protection inserted into bonds or loans sold by companies. With investors flocking to the higher yielding securities in recent years, corporate borrowers who issue sought-after debt have had the upper hand when it comes to negotiating protection.

In the loan market, deals with fewer types of investor protection have become the norm. A majority of new leveraged loans come in “cov-lite” form, eclipsing the 29 per cent reached at the height of the leveraged buyout boom just before the global financial crisis.

The preponderance of cov-lite has led to warnings from regulators including the Federal Reserve and the Office of the Comptroller of the Currency who have argued that the lack of “meaningful” covenants is a sign that “prudent underwriting practices have deteriorated”.

Junk bonds that lack covenants around issuing more debt or dividend payments, known as “high yield-lite”, accounted for 39 per cent of total sales in February, approaching the 41.7 per cent record set in September 2011, according to Moody’s, and up from 10 per cent in January.

Last month saw seven sales of high yield-lite bonds, including an offering from Netflix Inc and a deal from carmaker Chrysler Group.

Moody’s warned that relatively low issuance of junk bonds in February may have skewed its proprietary score, making it difficult to draw conclusions about the state of the wider market.

“When you’re looking at a small supply of deals in a month there’s only so much you can take away from it,” said Evan Friedman, Moody’s analyst.

Last month also bucked a historical trend in credit markets that sees investors demand more protection for lending to the riskiest credits. In February bonds rated “Caa” or “C ”, which equates to extremely speculative on Moody’s rating scale, recorded weaker credit protection than single B-rated bonds, the agency said.

“There are plenty of people that are going to buy the paper,” said Alexander Dill, head of covenant research at Moody’s. “One underwriter issues an aggressive structure and it is then replicated in the market. It’s hard to dislodge the worsening protections until something significant happens.”

US companies have sold $57.5bn of high-yield debt since the start of the year – a fifth lower than the $75.5bn sold in the equivalent period last year, according to Dealogic.

Issuance has slowed after companies with fragile balance sheets took advantage of low rates to refinance billions of dollars worth of debt in recent years, and as investors fret about the impact of a future rate rise on junk bonds.