Investors Fear Race to the Bottom as Bond Terms Ditch Safeguards

(Bloomberg) -- Junk bonds are increasingly adopting some of the lax terms from the loan market, a trend that investors say signals a deeper erosion in credit standards.

Companies and their private equity sponsors have been weaving looser conditions into deals, confident that strong market demand will outweigh concerns. The new documentation makes it easier for weak companies to borrow more debt, pay out dividends and invest cash elsewhere.

“If a sponsor can get cheaper prices in a more aggressive term loan, they will opt for that,” said Adam Zecharia, a partner at Allen & Overy. “So now we are seeing more high yield bonds accepting terms which were previously only accepted by loan investors to catch up.”

German technical-ceramics maker CeramTec GmbH sold a bond this month with a feature called an “available amount basket” that gives the company more flexibility with its cash. Modulaire Group, a designer of modular work spaces also sold debt at the end of last year with similarly lax terms. 

Investors and lawyers are pointing to a convergence in the terms for leveraged loans and bonds as larger deals combine the two, often with the same seniority. Traditionally, loans adopted covenants from their high-yield counterparts. But recently the roles have reversed. 

Investors say part of the problem is that these new terms add an additional layer of complexity. For example, bonds already have a so-called “build-up basket,” which sets the percentage of income that the company can use for dividends and outside investments. 

The “available amount basket” doesn't substitute, but rather goes on top of the build-up one in recently issued bonds. 

“Where the difficulty arises is that they are stapled onto one another,” said Alastair Gillespie, a senior analyst at Covenant Review. “It's nearly impossible to determine what the actual capacity for paying dividends is and for bond investors it becomes difficult to establish the potential for value leakage.” 

Other bond terms are allowing more flexibility in how covenants are calculated. By excluding some liabilities from leverage calculations or picking the right date, companies can easily pass covenant tests. 

That dynamic may change. It's been a difficult start to the year in the European high-yield bond market, with a slump in sales and a decline in secondary prices, because of inflation worries and geopolitical concerns. 

“Bargaining power on covenants and pricing is likely going to shift back and forth this year between investors and issuers,” said Sunita Kara, global co-head of high yield at Aviva Investors. “However, we are also likely to see loose covenants when primary supply eases up and the advantage then sits with the issuers.”

For the European Leveraged Finance Association, an investor lobby group that advocates for greater transparency from investors, the trend is worrying.

“When these provisions are included in bonds, how can investors hope to do these calculations?” said Sabrina Fox, chief executive officer at ELFA. “Doing these calculations was already difficult. How can bond investors understand whether these provisions make the terms riskier for them?”

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