* Bond covenant quality erodes in hot market conditions
* Almost 20% of deals issued in Q1 were high-yield lite
* High-yield returns still too attractive to turn down
By Mariana Santibanez
NEW YORK, May 29 (IFR) - Junk-bond investors are passing up
traditional protections in their race to buy new debt, and some
participants worry the diminished safeguards are a sign of an
One of the most troubling developments has been the rise of
high-yield lite bonds that give issuers wide berth but leave
bondholders facing especially heavy losses in case of default.
Combined with yields hovering near record lows for the asset
class, the eagerness with which investors are dispensing with
typical safety nets could mean trouble ahead.
"A low-rate environment is eroding covenant quality, which
recently reached an alltime low and is showing few signs of
improving," said Alexander Dill at Moody's Investors Service.
"It shows investors are willing to give up protections in
search of yield."
Moody's said that, on a three-month rolling basis, covenant
weakness in bonds rated B1 and lower reached the highest in
April since the rating agency began tracking it in 2011.
More than 19% of issuance in the first quarter of 2014 has
been high-yield lite, which is almost triple the figure in the
same period three years earlier, it said.
High-yield lite bonds do not have debt incurrence or
restricted payments covenants. The debt incurrence covenants
restrict a company's ability to add more debt while restricted
payments covenants limit what the issuer is allowed to do with
cash or other assets generated.
Those structures give borrowers freedom to increase leverage
or make acquisitions even if their businesses are struggling,
which makes already risky structures riskier still.
Recent notable high-yield lite deals include April trades
from natural gas giant Cheasapeake and debt-laden media company
Clear Channel Communications.
Clear Channel refinanced 2016 maturities that many in the
market had previously thought were headed for default - and did
so with a 10% coupon high-yield lite deal.
"What we are seeing are capital structures getting pushed to
the max, and terms becoming issuer-friendly," said Richard
Zogheb, co-head of capital markets origination for the Americas
Overall, investors are embracing greater risk in exchange
for relatively little yield.
Unlike the juicy double-digit coupons from Clear Channel,
for example, returns on offer are close to record lows for the
The yield-to-worst on the Barclays high-yield index dropped
to 5.03% on May 28, within spitting distance of the record low
4.95% marked on May 9, 2013.
Predictably, the combination of low-cost funding and reduced
protection for bondholders has brought junk-bond borrowers to
the market in droves - especially as the Fed was also trimming
its asset-buying program.
Supply since the start of April is at nearly US$71.5bn,
ahead of the US$67.9bn in the same period a year ago.
Year-to-date volume, which was down some 20% from 2013 at the
end of the first quarter, is now down just about 10%.
"As the Fed scaled back its bond purchases, issuers began to
get more nervous that the market would turn negative," said
Zogheb. "So they have been accelerating their deals."
Yet the diminished yields do not seem to be a problem for
According to data from Bank of America Merrill Lynch,
high-yield has returned around 4.38% this year, which is ahead
of the equity markets which returned 3.88% year-to-date.
"Volatility is low, defaults are low and growth is steady,"
said Stephen Kotsen, a high-yield portfolio manager at Nomura
Corporate Research and Asset Management.
And many market participants insist the market is not back
to the boom and bust days of the leveraged buyout boom.
"You are not seeing challenged credits come to market like
we saw in 2006/2007," Zogheb said.
Indeed, despite the erosion of investor protections,
defaults do not seem to be on the rise - in part because
investors have been willing to help issuers like Clear Channel
push out maturities.
The US high yield par default rate was 13.7% in 2009 and
2.8% on a trailing twelve month basis through April 2014,
according to Fitch Ratings.
Even so, Fitch has warned that the level of riskier debt in
the market is significant.
It said US$403bn in notes rated B minus or lower are
currently outstanding - way up from US$354bn at the end of 2009
and the even lower US$329bn at the close of 2011.
And leverage is on the rise too - another warning sign.
Aircraft component maker TransDigm, for example, last week
managed to attract more than US$8bn in demand for a new deal to
partly finance a dividend. Though it had covenants, the deal
took leverage up to 7.4 times - well past the 6.0x level
regulators have warned underwriters not to surpass.
"When companies could only get 5.5x leverage a year or so
ago, some can now get a low 7x," Zogheb said.
(Reporting by Mariana Santibanez; Editing by Natalie Harrison
and Marc Carnegie)