Junk bonds are getting junkier
ONE thing owners of junk bonds are usually sure of is that when the borrower defaults, they will get a veto on cash going to shareholders, to junior debtors or into new deals.
Not any more. Junk bonds financing private-equity firm KKR & Co’s latest buyout subvert the usual order by allowing such payments to go ahead even after a formal default.
The US$1.4bil of bonds, to repay temporary borrowing for the buyout of Unilever Plc’s margarine business, mark a new low in the quality of covenants protecting lenders and are yet another sign of the wall of money chasing the higher yield on offer from junk bonds.
Several recent bonds have allowed what are known as restricted payments even when a company is in technical default – so that, for example, a planned takeover or joint venture wouldn’t be derailed. Flora Food Group, Unilever’s business, appears to be the first explicitly to allow them after a formal “event of default”, which should put creditors at the front of the line.
This matters when it comes to assessing the risk of the market as a whole. Junk-bond enthusiasts tend to highlight the yield spread over treasuries, which in the US is much higher now than it was at the end of the last bull market in 2007, and about where it stood in 2014.
But the weakening of covenants means that losses are likely to be bigger if there is another wave of defaults, which ought to justify lower prices (and so higher spreads over treasuries). Weaker covenants have also taken away much of the possible upside if the company performs surprisingly well, in part by allowing early repayment with fewer penalties.
If shareholders get more of the gains when things go well and bondholders get more of the pain when they go badly, bondholders ought to pay less to take on that risk. Adjust for this and the comparison with 2007 looks less reassuring.
This subversion of the priority of creditors is a concerning point of principle, but might be less important for Flora bondholders than the extreme weakness of other protections they usually rely on. Moody’s Investors Service rated Flora’s bonds as Europe’s worst-ever, scoring 4.99 out of five for weakness of covenants. Only a handful of US bonds have scored the full five.
Jason Suh, a former corporate-finance lawyer now at analysis firm Covenant Review, says the other restrictions are so weak that the question of formal default might be academic. “The covenants are so bad on Flora that it would be hard for the company to end up in an event of default,” he said.
Investors and lawyers say that the sheer amount of money chasing deals allows high-profile issuers to get away with terms that would never have been accepted in the past, although some less well-known issuers have been forced to tighten proposed covenants recently. There have also been spillovers from the standardisation of “covenant-lite” terms in the leveraged loans used by private equity.
Mitch Reznick, co-head of credit at Hermes Investment Management, says in part this is because worries about rising long-term bond yields have increased demand for floating-rate loans and for bonds with short durations, as junk bonds usually are.
“There’s convergence in the structure and debt-protection language in the loan market and high-yield (junk) market,” he said. “It’s this incremental degradation that we’ve had through a period of really low volatility.”
“If-when-we get a period of extreme volatility I think that will reset things, it will become more of a buyer’s market than a seller’s market.”
For now issuers are taking full advantage of the demand, and not just by weakening covenants. Weaker companies are also tapping the market. Moody’s calculates that almost 36% of US junk-rated companies are rated in B’s lowest level or are already rated C, the riskiest grouping, higher than at the peak of the last recession.
However, default rates are extremely low, despite a pickup in the first quarter as retailers struggled with the shift to online shopping. Weaker covenants could allow companies to survive longer before defaulting, too, helping keep the default rate lower for longer than usual.
Such a low default rate could be good or bad for bondholders, depending on where the companies eventually end up. A shallow and short economic downturn might lead to fewer defaults than in the past, thanks to weaker covenants, and if the companies ultimately survive that is the best outcome for creditors.
But if there is a proper recession and defaults pick up, creditors could lose even more than in the past as companies with weaker covenants burn more cash before they die, leaving less for creditors picking over the bones.
Since Flora’s bond was sold it has dropped in price, and now yields 8% in dollars and 6% in euros.
Ultimately investors face a problem, because so many asset classes look expensive and overleveraged. But don’t be fooled into thinking junk bonds are reasonable just because they offer a higher premium over safe government debt than in 2007.