Amid a healthy appetite for yield, and an otherwise low-return environment, high-yield bond and leveraged loan covenants are continuing to deteriorate, says Moody’s Investors Service in a new report — which leaves investors and lenders more exposed.
The rating agency says that high-yield bond covenants have deteriorated by many measures over the past year. The decline has occurred across all of Moody’s high-yield risk categories, and across all major North American corporate sectors, and now reaches deeper into speculative-grade rating territory, it reports.
Moody’s Covenant Quality Index measures high-yield bond covenant quality on a five-point scale, with 1.0 representing the strongest investor protections and 5.0, the weakest. The index hit a record low of 4.23 in November, and since then has shown no appreciable improvement, Moody’s says.
“Investors’ hunt for yield underlies the broad degradation in covenant quality,” says Alexander Dill, vice president and head of covenant research at Moody’s. “Low interest rates have led money managers with large amounts of cash to seek high returns for their clients, and encouraged by demand, issuers have offered bonds with ever more flexible covenant structures, leading to a ‘race to the bottom’ as underwriters compete for issuers’ business.”
Moody’s predicts that issuance will diminish as the U.S. Federal Reserve winds down its asset purchase program and eventually raises interest rates. And, as investor demand for high-yield debt drops off, covenant quality will improve, at least marginally, it suggests. “But it will take a major macroeconomic event that severely weakens credit fundamentals and significantly tempers investors’ risk appetite, such as a bank failure or war, to dislodge precedents that have become embedded as the norm,” notes Evan Friedman, vice president and senior covenant officer at Moody’s.
The rating agency says that that covenant quality has also diminished in the leveraged loan market over the past few years. Indeed, it says that so-called “covenant-lite” loans, which give lenders nominal rights, accounted for just 3% of total institutional loans back in 2010, but that they now account for 60% of total loans.
“An increasing number of senior lenders are accepting weaker loan protections,” says Jessica Reiss, Moody’s vice president and senior covenant officer, in a separate report. “Our analysis of a pool of publicly filed loans from 2008 through the first half of this year shows that loan terms have become less protective,” she notes. And, as a result, Moody’s loan covenant quality scores have eroded in the past two years, Reiss says.
On a similar five-point scale, Moody’s reports that in the first quarter of 2013 the average score was 3.59, and by the end of 2014’s second quarter it was 3.81. And, it says that approximately 42% of the loans Moody’s analysed fell into the “weak” and “weakest” categories in 2012, but that figure rose to about 60% last year and 65% in the first half of this year.
The report also notes that, while issuers backed by private equity have traditionally used covenant-lite loan structures, this trend is spreading to other companies.