A Warning From the Debt Markets

Any time a room full of professional investors are all talking about the same thing that most everyday investors aren’t even aware of… it’s time to worry.

That’s exactly what happened at the CFA Society’s High-Yield Bond Conference two weeks ago. It’s a must-attend for any type of high-yield investor.

The conference was held in New York City and it had a wide range of speakers – including a CEO of an asset-management firm, various portfolio managers, directors from credit-rating agencies, and more. And the topics they covered were even more broad – ranging from high-yield technical analysis strategies, the state of the market today, and the role of exchange-traded funds (ETFs) in high-yield bonds.

Out of all the presentations, no matter the topic, one thing was brought up time and time again… covenant quality.

Covenants are basically rules that borrowers and lenders agree upon for debt such as loans or bonds. Covenants are in place to enforce what issuers are required to do (positive covenants) and what they cannot do (negative covenants).

A common example is a restricted payments covenant. These protect the lenders by limiting the company’s ability to make undesirable distributions and asset transfers that would hinder the borrower’s ability to repay the debt. This can include restrictions on stock repurchases, prepaying junior debt, and dividends. Other covenants may require certain debt-to-assets or interest coverage ratios.

Over the past few years, covenant quality has declined dramatically in the form of leveraged loans.

Leveraged loans are loans issued by firms with below-investment grade ratings and typically have quite a few covenants in place to protect the lender. A covenant-lite loan has less restrictions and therefore more risk.

The numbers speak for themselves…

U.S. covenant-lite loan issues for 2017 were the highest in over a decade at a record $677 billion. This is roughly double the $350 billion the previous year and far more than in 2007, at about $150 billion. So far in 2018, we’re on pace to issue over $600 billion once again. Consumer discretionary and technology borrowers have issued the most year to date.

Moody’s Covenant Quality Indicator shows we’re near record lows in high-yield bond covenant quality as well. The indicator recently showed a score of 4.32, with a score of 1 denoting the strongest investor protections and 5 the weakest.

It’s the 11th consecutive month above 4.2.

If you think we learned our lesson about loading up on risk in 2007… we haven’t. We’re taking on record amounts of risk with the rise in covenant-lite leveraged loans.

About 77% of new loans issued are covenant-lite. Covenant-lite has become the standard. And that’s worrisome…

So much so that almost every speaker at the conference brought this up to illustrate the amount of risk investors are taking in the high-yield market.

With fewer covenants or weaker covenants, firms can make decisions that put their own agenda or their shareholder’s needs over their debt holders.

The increase in covenant-lite loans is not going to be a major catalyst to a market downturn. But when the credit cycle does turn, the declining covenant quality will make things ugly. Recoveries on defaulted debt will be significantly impacted.

This is happening right as interest rates are on the rise, which will make it harder for firms to pay off their debt.

And with the total amount of debt that firms have amassed over this prolonged period of low interest rates, it’s safe to assume we’ll see a pickup in defaults sooner rather than later.

The high demand for these loans is a clear signal that we’re getting near the end of this business cycle.

Right now, it’s better to have a defensive mindset than an offensive one.

What We’re Reading…

Here’s to our health, wealth, and a great retirement,

Dr. David Eifrig and the Health & Wealth Bulletin Research Team
June 27, 2018