Kames Capital’s high yield team has issued its strongest warning yet that investors could lose out as the terms designed to shield them from losses get watered down
The team has cautioned on the deterioration of high yield ‘covenant’ protections before, but in a note sent to investors earlier this month it warned that a new wave of European issuers is increasingly looking to soften covenants as it enters the market.
Claire McGuckin, who works with Phil Milburn on the group’s £1.5bn High Yield Bond fund, said the number of European high yield issuers rose by 10 per cent in the first six months of 2013 alone.
“The high yield bond market is experiencing another period of new issuance, accompanied by more aggressive structuring whenever companies believe they can get away with it,” said Ms McGuckin.
“Many of these new issuers are reasonably small, niche businesses, and are untested in a public debt environment in terms of accuracy of information and financial expectations.”
The note identified five areas in which high yield covenant protections – the legally binding terms that are struck when a company accepts money from a bond investor – are being eroded.
The first area is subtle changes to the ‘change of control’ clause that forms part of a high yield bond’s portability covenants.
This clause gives investors the option of getting their money back, and a tiny bit more, from a bond issuer in the event that it is bought out – something that comes in handy if a company is acquired by a higher-risk firm, triggering losses on its bonds.
But new European issuers are increasingly weakening the clause, adding new caveats that allow them to get off the hook from repaying investors in certain circumstances.
According to Kames, another key area of erosion is restricted-payments clauses, which limit how much money companies can hand to shareholders in the form of dividends.
The third area is incurrence tests, which aim to limit the amount of debt a company can accrue after it sells its bonds. Ms McGuckin said issuers are relaxing the rules around conditions they have to meet before they can issue new debt, shifting to an ‘affordability test’ rather than being limited by the ratio of leverage to company valuation.
The fourth area of erosion is the implementation of shorter non-call periods, a change which “moves the scales in favour of the company” in subtle ways, the manager said.
The final area is the rising addition of payment-in-kind notes to covenants. These enable bond issuers to effectively roll over their bond debts by increasing the amount of capital due at maturity rather than paying their regular debt interest in cash.
“While companies have always taken advantage of opportunities to raise funds on the most advantageous terms possible, it has never been more important for managers to remain vigilant and to undertake in-depth analysis of covenants,” Ms McGuckin added.
