Don’t ignore covenants

Covenants are important because what a bondholder might lose or recover from a defaulting credit does not depend solely upon the severity of corporate events that lead to default. Where a given bond sits within the capital structure, the collateral and guarantees provided, and the rights of bondholders to act vis-à-vis other stakeholders are equally important.

Alongside the business risks of the borrower, the legal rights of the creditor and obligations of the bond issuer are detailed in the bond’s indenture and summarised in the offering memorandum. These key details determine what recoveries might look light in the event of insolvency. Strong creditor protections can mean that even in a default, creditors still can be repaid in full. In other words, why should default be one’s only concern if the resultant loss can range from significant to nil?

The devil is in the detail

A superficial glance at any high yield bond prospectus will reveal the same standard suite of covenants both financial (i.e. tied to specific financial metrics) and non-financial. High yield analysts will be familiar with headings such as Limitation on Indebtedness; Limitation on Asset Sales; Limitation on Restricted Payments; and Limitation on Liens. These provisions are meant to prevent or at least limit the ability of leveraged borrowers to act in a manner that is detrimental to the interests of creditors, such as taking on too much additional debt, removing key assets without debt repayment or distributing value to equity holders before repaying creditors.

The presence of such standard clauses might look reassuring to potential investors, but the devil is in the details that accompany these provisions. Leveraged credit recently has been marked by the same “shrinkflation” that shoppers have experienced in consumer goods. While the outer packaging looks the same, a closer reading of the terms reveals that investor protections have diminished.

Ironically, it often takes issuers’ lawyers more words to provide bondholders with far less. A litany of exceptions (carve-outs) to once standard protections allow the borrowers to take on more leverage, dilute collateral and transfer more asset value away from creditors, leaving less investor protection in a default.

Covenant quality is eroding

Financial covenants that rely on a calculated metric to assess compliance are one example of this weakening protection. For instance, a Consolidated Total Leverage Ratio should be calculated as debt to earnings before interest, taxes, depreciation and amortisation (EBITDA). However, the definition of Total Leverage and EBITDA often will allow borrowers to exclude various amounts from the debt calculation while at the same time allowing numerous hypothetical add-backs to actual operating profits. Some clauses even allow borrowers to choose the optimal calculation date.

Such flexibility on how and when financial covenants are calculated and tested can forestall the ability of creditors to call an event of default. The erosion of covenant quality is intended to tilt the balance of power and the economics away from creditors toward equity holders. Lower recoveries for creditors mean higher potential losses given default, thereby increasing credit risk.

Weak covenants have a cost

Defenders of the idea that bond covenants don’t harm investors might profess that covenants still do not matter because they tend to sell poorly performing credits before needing to test the strength of their creditor claims in an insolvency. This logic defies market reality. Every seller needs a buyer and an informed purchaser of a poorly performing credit will know the risks weak covenants pose to recoveries and will reflect this in their bid. Ultimately, investors are still paying the price for weak covenants upon exit.

So long as the prevailing attitude is that weak bondholder protections do not matter, market participants are unlikely to receive adequate risk compensation when deals price. Making matters worse, any hint of indifference encourages issuers to push the limits of investors’ tolerance for ever weaker covenants.

Understand all the risks of investing

Until the tide turns and the supply of leveraged credit exceeds investor demand for high yield risk, it is difficult to imagine a wholesale tightening of covenant terms. For exactly this reason we think it is essential to communicate to underwriters during the book building process that the price we have in mind reflects not just the risk of default, but the extent of resultant loss imputed by weak investor protections. 

We do not and cannot take a view on relative value without incorporating an assessment of the strengths and weaknesses of the terms under which we are lending alongside our understanding of the borrower itself. A thorough review and comprehensive understanding of covenant risks is an integral part of our fundamental credit analysis. In our view, to be forewarned is to be forearmed.