For junk-bond investors, the trade-off between lender protections and yield has never been worse, according to Moody’s Investors Service.
More than a third of new speculative-grade bonds issued in North America in the second half of last year lacked one or both of the most critical creditor safeguards, the highest percent ever in data going back to 2011, analysts led by Evan Friedman wrote in a report released Thursday. A Moody’s gauge of covenant-quality, in which 5 indicates the weakest protections and 1 the strongest, declined to 4.26 in the period from 4.14 during the first half of 2014. Covenants are protections written into bond documents that can restrict an issuer’s ability to borrow more.
Record-low borrowing costs due to global central bank easing have shifted the balance of power toward borrowers, according to Friedman, as investor demand for higher-yielding assets gives issuers an upper hand in negotiating terms. Companies with speculative-grade ratings have issued $245.9 billion of bonds worldwide this year after selling a record $724.4 billion in 2014, according to data compiled by Bloomberg.
“In an environment where deals are oversubscribed, the squeaky wheel gets the axe,” Friedman said in a telephone interview. “Interest rates have stayed low so long that you have very little covenant protection left to trade.”
Flexible covenant structures have embedded themselves as the norm in deals as underwriters compete for business, Friedman wrote in the report. Out of 170 junk deals in the last six months of 2014, 38 percent percent lacked either or both restricted payments and debt incurrence covenants, the safeguards Moody’s deemed most critical in ensuring creditors get their money back.
“I’ve met with investors who shrug their shoulders, recognizing that if you want to be in the deal, this is the current environment that you have to give up,” Friedman said by phone. “At some point that will shift and the investors will make their desires clear to the underwriters.”