Investor protection on HY bonds hits low in January: Moody's

Tue Feb 12, 2013 1:11pm EST

Feb 12 (IFR) - Covenant quality on North American high-yield bonds declined to its lowest-ever level in January, mostly due to a spike in issuance of high-yield-lite bonds, Moody's Investors Service said on Tuesday.

High-yield-lite bonds provide investors with fewer protections than full covenant bonds on payment terms and collateral.

The Moody's Covenant Quality Index declined to 3.89 in January from 3.79 in December. The index measures covenant protection on a scale of 1 to 5 with 5 being the weakest. Moody's has tracked the CQI since January 2011.

"Weakening covenant scores show that investors are taking on more covenant risk despite less yield, as average spread to benchmarks tightened in the 2nd half of 2012, fueled by strong investor demand and record volume of HY issuances," Moody's analysts said in a report.

The deterioration in covenant quality started last July and has continued every month since then for different reasons, the agency said.

In September, for example, 34.6% of bonds issued with Single B ratings had the weakest covenant score, compared with a historical average of 21.1%.

In October, there was a spate of payment-in-kind (PIK) issuance. PIK deals give the issuer the option of repaying the debt in kind -- i.e., by issuing more bonds instead of paying cash.

Since then, more companies have issued high-yield-lite bonds, including Netflix, jet maker Lear, packaging company Crown Americas, food packager Sealed Air and chemicals company Huntsman.

In January, homebuilders D.R. Horton Inc. priced two such deals and Lennar Corp issued one. Homebuilders are typically big issuers of high-yield-lite bonds.

January's reading was also hurt by an increase in issuance of bonds rated at Ba, which accounted for 58% of high-yield supply in the month, well above the historical average of 27%, said Moody's.

Bonds with that rating generally have more relaxed covenant packages as investors are willing to tolerate less protection in return for less-risky debt than found lower down the credit spectrum.

There was also an increase in the number of bonds rated Single B that had weaker-than-average covenant quality.

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