Standard & Poor’s recently warned about record sales of so-called ‘cov-lite’ loans and it is a timely reminder of the dangers lurking in the high yield bond market.
Some managers share S&P’s concern the move could lead to a refinancing crisis in 2017-19, or a spike in defaults in the event of a liquidity crisis, and that more attention should be paid to covenant quality.
Covenant-lite loans are those with limited restrictions on the borrower in terms of necessary collateral, payment terms and level of income.
Caspar Rock, Architas chief investment officer, says: “The old joke is that when animal spirits are raised these investments are classified as ‘high yield,’ but when animal spirits turn, they are ‘junk’.”
But Chris Higham, Aviva Investors’ Strategic Bond fund manager, sees the decline in covenant quality as a US phenomenon, and that shorter term participants in credit markets are more likely to make the mistake of ignoring covenant quality.
“While the quality of covenants is starting to decline in Europe, in the main the European market is still being fairly disciplined,” he explains.
“While there is likely to be some concern over certain names issuing bonds, a lack of covenants can give companies more flexibility and may well even result in lower default levels.”
Stephen Baines, a fixed income investment manager at Kames Capital, agrees a general loosening of credit standards is taking place in the high yield bond market, as investors accept lower quality issues to achieve a given yield.
“Lower quality or more highly-leveraged businesses are able to raise finance and the terms and conditions on which that finance is raised, namely the covenants, are being eroded.”
Christine Johnson, bond fund manager at Old Mutual Global Investors, says ‘cov-lite’ matters because recovery values on traditional high yield bonds average approximately 40 per cent, whereas on cov-lite loans or bonds, it is frequently closer to zero.
David Ennett, Standard Life Investments’ high yield investment director, believes while there has been some relaxation of covenants, these have focused on investors negotiating away potential upside, such as allowing partial calls in non-call periods, lending portability and so on, rather than core protections such as security packages and reporting requirements.
“Where we have seen this, active high yield bond managers still possess a much under-heralded power: not buying a deal – something for debt-market exchange traded fund proponents to consider.”
Bill Harer, Canada Life Investments’ joint manager of the CF Canlife Corporate Bond fund, agrees that index-tracking bond funds are under pressure to buy cov-lite bonds, irrespective of quality.
“It is a concern for us,” he says. “Index-matching is one of the factors that makes it easier to issue bonds with few covenants, because if it is in the index and is investment grade, people will buy it.”
Evan Moskovit, ING Investment Management’s head of global investment grade credits, warns against complacency, given the balance of power since the financial crisis has shifted from investors to issuers.
“Investors believe that corporate credit defaults, which are running well below historical averages, [roughly 2 per cent, compared with approximately 4 per cent plus historically], will remain a non-event for the foreseeable future,” he explains.
“Post 2008, and for the following few years, investors had the upper hand with tight credit controls, high coupons and a say in developing bond structures and terms. In the past few years, the pendulum has swung in the direction of the issuer.”
So what are the implications of record sales of cov-lites for the bond market?
Kames Capital’s Mr Baines says cov-lite loans are not necessarily bad instruments, and that empirical evidence suggests they default at a much lower rate than loans with covenants, and that when they do default, the recovery rates are similar.
“Therefore, when interest rates rise, covenant-lite loans are likely to perform no worse than other loans,” he says.
“However, as a lender, I would rather have covenants than not, so the boom in covenant-lite lending does suggest that investors are having to loosen their credit standards to put money to work.”
Canada Life’s Mr Harer says: “As the saying goes, when the tide goes out, you can see who’s been swimming naked.
“When the market does turn, with less liquidity among market-makers nowadays, it will be difficult for investors to sell these bonds at current prices.”
ING’s Mr Moskovit says a lack of appropriate covenants can allow a company to operate too long in a deteriorating situation or become overly aggressive.
“Covenants are designed to provide boundaries for companies to operate within and operational health checks for investors,” he warns.
Peter Aspbury, JPMorgan Asset Management’s European high yield portfolio manager, says there will still be demand for cov-lite loans when interest rates rise.
“I would say the risk is that, in a rising-rate environment, investors will overvalue leveraged loans for their built-in duration hedge and neglect to pay enough attention to the credit risk of the asset class.
“It will be a spike in default risk, rather than a rise in interest rates, that will remind people of the perils associated with over-leveraged capital structures and loose covenants.”
