The warning caveat emptor, or “buyer beware,” is particularly important to heed when investing in bonds late in the credit cycle. At those moments, issuers are pursuing more aggressive refinancing or acquisitions, underwriters are letting weaker credits slip through the cracks, and investors starved for yield are increasingly willing to hold their noses to outperform.
Case in point: Two recent deals highlighted what appear to be deteriorating underwriting standards and creditor protections, particularly prevalent in the high yield market where high-quality covenants—or just any covenants at all—are quickly becoming a “remember when” punchline. This deterioration has big implications for the speed and extremity of credit defaults, and for creditor recoveries once the cycle turns.
- Hearthside, a packaged food supplier, was sold in a private equity transaction featuring 7x leverage. The deal initially included provisions limiting bondholders’ recourse to asset sale proceeds, very liberal secured financing capacity, and essentially unlimited dividend capacity, although it should be noted that creditor pushback resulted in key amendments that strengthened the covenant package.
- Another private equity transaction involving SRS Distribution also features generous add-backs to earnings that materially inflate the company’s debt capacity, as well as the ability to divert asset-sale proceeds to pay dividends to equity holders (where those proceeds are typically reserved for debt reduction).
Covenant quality deterioration (and aggressive PE activity) are lamentably old news. In fact, the renewed rigor in financial documentation following the crisis started disappearing almost as soon as it began. As shown in the chart below, the volume of covenant-light (commonly referred to as “cov-lite”) issuance has skyrocketed since the financial crisis. According to Moody’s, cov-lite leveraged loans made up 80% of all issuance in 2017—a far cry from 2012, when cov-lite loans were in the minority, not the majority.
Letting Go of the Reins
Between June 2008 and May 2016, cov-lite debt issuance totaled about $1.14 trillion. Between June 2016 and May 2018, the total was $1.16 trillion. In other words, volume in the past two years exceeded that of the preceding eight years.
Source: Bloomberg.
Experienced credit investors are generally wise to how credit cycles tend to unravel—badly—but such widespread acceptance of porous documentation and weak covenants has serious implications for how quickly and how badly things can end in a given situation. Covenants generally act as triggers that slow an impending credit failure. Leverage maintenance covenants enable creditors to extract fees or impose restrictions on issuers that fail to meet them. Restricted payments rules prevent aggressive majority stakeholders from misappropriating liquidity when the issuer needs it most. Asset-sale and other distribution covenants ensure that actions taken by management result in healthier balance sheets, not healthier IRRs.
Without these rules, creditors are often stuck watching a train wreck in slow motion, with little recourse or negotiating power. Situations like these often wind up in “free-fall” bankruptcy, leaving stakeholders little time or ability to preserve value, as the bankruptcy code intends. That means deeper losses at a much faster pace. So in this late-cycle, “buyer beware” environment, credit investors who ignore the role of covenants in mitigating default losses do so at their own peril. 
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