Covenant cull spells trouble for creditors

IFR 2253 29 September to 5 October 2018
5 min read
Americas
Natalie Harrison, Joy Wiltermuth

Weaker protections in US junk bonds and leveraged loans by companies targeting ambitious cost cuts and earnings growth are stoking fears of bigger losses in the next downturn.

US high-yield default rates were just 3.4% in August, and are forecast to drop to 2.1% this time next year, according to Moody’s. But the focus on the next potential default cycle – even if it is some way off – is more about how steep losses will be than the default rate itself because of the proliferation of exceptionally loose covenants.

“Covenants are a growing concern,” Mark Howard, senior multi-asset specialist at BNP Paribas, told IFR.

“Weak covenants reduce the probability of default but they increase the severity of default.”

Moody’s recently warned that average first-lien term loan recoveries are expected to tumble to 61% from an average of 77% historically, and the Bank for International Settlements said this month that loan investors should expect bigger losses.

“Loan recovery rates during the next downturn could be smaller given that the debt cushion – ie, the level of unsecured junior debt that absorbs losses before senior loans in a default – of leveraged loans has decreased,” the BIS wrote.

Another concern is that loose covenants will allow private equity owners to move assets out of the reach of creditors, and pay themselves dividends even in times of financial distress – and that investors will have very little recourse.

Struggling retailer PetSmart – bought by a private equity group led by BC Partners in 2015 – is a good test case.

After its buyout, PetSmart bought online retailer Chewy in a bid to boost sales, but a year later the sponsors took 20% of Chewy for themselves (via a dividend), and moved another 16.5% to a so-called unrestricted subsidiary. PetSmart’s creditors now only have a claim on roughly 63.5% of Chewy.

“It was a shock and a very bad outcome for bondholders,” said a banker close to the situation. “But the covenants allowed it.”

Yet investors have accepted arguably worse terms of late – fanning worries about what might happen if other leveraged buyouts sour.

Covenants on junk bonds sold this month for Refinitiv (the new name of Thomson Reuters’ Financial & Risk business that includes IFR), Akzo Nobel’s speciality chemicals business and Envision Healthcare allow owners to pay dividends even when in default.

IT’S A KNOCK-OUT

Weak covenants are all part of the “wink and nod” negotiations between sophisticated sponsors and creditors.

Investors are mostly assessing whether a business will succeed, if sponsors will use the flexibility loose covenants allow, and if the extra yield they’re usually offered is enough to offset the extra risks.

But David Knutson, head of credit research Americas at Schroders, is worried that greed is overruling common sense.

Weak covenants and creative accounting metrics – including add-backs that inflate pro forma earnings estimates and lower headline leverage multiples – are both worrisome, he said.

“It’s a double punch: they’ve got you with the left and they’re going to punch you with the right,” Knutson told IFR.

Covenants, a bit like an annual health check, can help reveal potential business problems early on.

“If you have a real loose covenant package you can go two, three or four years without a check-up. Sometimes that’s not good. You don’t have an early warning to change behaviour,” Knutson said.

In some cases weak covenants can work out well for bondholders – especially for cyclical companies.

They stand a chance of benefiting from a recovery if management is given time to work through a difficult period, instead of being wiped out in an early restructuring controlled by first-lien investors.

But on the whole, weaker protections are unlikely to be a good thing for investors.

“We would rather be able to use covenants to help determine the outcome,” said Adam Spielman, head of leveraged credit, total return at fund manager PPM America.

Howard at BNP Paribas said his bigger worry is accounting tricks.

Take Blackstone. It factored in US$650m of cost-saving projections in its pro forma earnings estimate for Refinitiv.

But factors out of its control – such as cuts on Wall Street that could narrow its client base – may make that unattainable, some investors said.

“Covenants are a known concern. Markets are less vulnerable when things are flagged and identified so investors won’t be surprised,” said Howard.

“Shocks and surprises are what create real market disruption. People should be paying more attention to the accounting.”

Ukraine: DTEK's 2015 bonds face chopping block