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The legal restrictions on what high-yield bond issuers can do once they raise money are growing looser by the day. Strangely, investors don't seem to mind.
Known as covenants, these rules set limits on everything from how much additional debt the issuer can tack on, relative to its cash flow, to what type of investments the company can make.
For a quality issuer, these restrictions aren't so important because the company often operates well within its limits, but high-yield issuers are by nature much riskier investments and are more prone to flirting with trouble.
Case in point: Canada's SkyLink Aviation Inc., which just filed for creditor protection. After a private equity takeover, the company raised high-yield debt that paid a 12.25 per cent coupon annually, which the company couldn't maintain because its costs and revenues were variable.
Moody's Investors Service rates the quality of North American bond covenants on a scale of 1 to 5 (1 being the strongest and 5 the weakest), and its latest reading of 4.18 is the lowest since the index was initiated in January 2011 when the high-yield market surged after the crisis.
The culprit: a flurry of high-yield issues with lite-covenant packages, as they are known. These types of bonds made up 33 per cent and 40 per cent of all new issuance in January, respectively, more than double their average of 16.5 per cent since the index started. Loose covenants are most common in new issues from home builders, hospitals and steel companies.
But while loose restrictions are most common in certain industries, they're seen across the entire high-yield ratings scale, from Ba to Ca. In general investors actually get better protection with riskier companies, because they know the issuer is troubled, but covenant quality is now below the historical average for all the high-yield ratings.
The scary thing is that investors don't seem to care. Moody's tracks high-yield spread movements relative to its covenant index and found that spreads have tightened significantly since last summer, all while covenant quality deteriorated. The 3-month rolling spread for high-yield bonds to their benchmark is now about 500 basis points, down from 650 basis points in July 2012.
Nor has it slowed down the issuance of high-yield debt. While high-yield exchange traded funds have seen some eyebrow-raising outflows in early 2013, the new issue pipeline remains solid. A record $366-billion (U.S.) debt was sold in the U.S. last year, according to UBS, and by the end of February more than $50-billion had already been issued in 2013.
(Tim Kiladze is a Globe and Mail Reporter.)
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Tim Kiladze