“Experience is the name everyone gives to their mistakes”
Oscar Wilde (1854 - 1900)
Avoiding the Losers
At Hotchkis & Wiley, we believe that averting mistakes is the single most important quality in successful high yield investing. We are not immune from making mistakes, but seeking to avoid high defaults and low recovery rates can be a key tenet of our strategy. This “avoid the losers” mentality can be achieved by focusing on several factors. First, we have a preference for securities that are senior in the capital structure, i.e. we prefer senior or senior secured to subordinated bonds. Second, we emphasize asset coverage, where the value of the assets provides more-than-sufficient support. Covenant packages represent a third layer of defense that we believe is often overlooked.
A tight covenant package guards against management behaviors that might be favored by equity shareholders or other stakeholders, but could put bondholders at risk. The level of conservatism exhibited by covenant packages varies with the credit cycle. When spreads rise and investors become more risk-averse, covenant packages tend to become more restrictive. Conversely, when spreads narrow and investors become less risk-averse, covenant packages tend to become lax. Today’s spread environment resembles the latter, so we thought analyzing covenant trends would be a productive exercise. This newsletter will attempt to identify broad trends in covenant packages by dividing covenants into three categories: 1) redemption flexibility; 2) negative covenants; and 3) change of control provisions.
Before we begin, it is important to note that we view covenant packages as an important risk control but one that is tertiary to seniority and asset coverage. An air-tight covenant package cannot transform a bad credit investment into a good credit investment. Conversely, a senior secured credit with tremendous asset coverage but a weak covenant package could still be a good investment.
Special note: Because covenants are idiosyncratic, analyzing broad trends is complicated. In fact, obtaining and aggregating reliable data is a challenge. To this end, we would like to extend a special thanks to Xtract Research (www.xtractresearch.com), which has done extensive, first-rate work on credit covenants. Much of the data provided hereafter was derived from Xtract’s pioneering research.
I.Redemption Flexibility
The terms and timing with which a bond can be redeemed is one of the most important covenants for investors to consider. All else equal, the more flexibility issuers have to redeem its bonds, the less appealing the terms for investors.
Historically, most high yield issues contained a covenant denoting that the bond could not be redeemed by the issuer until a specified period had elapsed. The most common period was the bond’s half-life; i.e. 4 years for an 8 year bond. In credit vernacular, this feature is most often referred to as call protection—a characteristic absent in most leveraged loans. From the investor’s perspective, reinvestment risk increases when the issuer can call the bonds. The investor receives cash for the bonds, which is likely to be invested in a less favorable interest rate environment. Setting aside interest rate considerations, the longer the non-call period is the better for the investor. Chart 1 depicts the number of new high yield bond issues that contain an explicit non-call period covenant . The current market standard is an 8 year bond callable after 3 years. The number of bonds issued that contain a non-call period of less than three years, however, has increased considerably in recent years.
Other factors influence Chart 1, in our opinion, which lead us to believe that the shift in non-call periods goes beyond covenant relaxing. First, the Federal Reserve has purchased a considerable supply of high quality debt, which has prompted high grade investors to explore the high yield market for relative value opportunities. This has shifted the high yield market’s investor base to a group that is less accustomed to the complexities of call-protected securities. Second, investors appear reluctant to invest in long duration bonds given the ultra-low interest rate environment. A short no-call period has a smaller impact on a short-duration bond than on a long-duration bond.
The equity clawback provision is another redemption-related covenant. An equity clawback enables the issuer to redeem some percentage of the outstanding issuance financed with proceeds from an equity offering. The most common terms historically, by far, has been the 35/65 standard—the issuer is permitted to redeem up to 35% of the issue from initial public offering (IPO) or secondary offering proceeds (at par plus coupon) while 65% remains outstanding. We recently encountered covenant packages that watered down this standard, permitting 40% of outstanding issuance to be clawed back. Chart 2 tests our suspicion by dividing all new issues with an equity clawback provision into two buckets. This covenant appears to have remained relatively consistent in recent years, with the 35/65 standard outnumbering more lenient terms by a 2 to 1 ratio, approximately. The last time we observed an increase in the number of issues with clawbacks in excess of 35% was leading up to the financial crisis. Current trends suggest we are heading that direction, but if history is guide, we would need a few more years of solid equity returns before this covenant deteriorates in a concerning manner.
A new redemption feature has been introduced in recent years, which permits the issuer of senior secured bonds to redeem up to 10% of outstanding issuance per year at 103% of par value. Typically, this provision is in effect for the first three years after issuance, which is normally the non-call period. This feature provides additional flexibility for the issuer, which is inherently bad for investors. Chart 3 shows the prevalence of this feature in recent years, which has been around 20% of all newly issued senior secured bonds over the last several years.
Based on Charts 1, 2, and 3, covenants related to redemption flexibility exhibit mixed trends. We contend that overall, redemption covenants have trended a bit looser recently primarily because the non-call period has been shortened. This increases reinvestment risk for the investor, which is particularly acute in low interest rate environments.
II.Negative Covenants
A negative covenant is intended to prevent management from certain activities that could be detrimental to bondholders—it is an agreement to not do something. The most common negative covenants (also referred to as restrictive covenants) are designed to limit the amount of financial leverage the borrower can assume. One such covenant that has been popular through time places a minimum threshold on the fixed charge coverage ratio (“FCC”).
Common Fixed Charge Coverage Ratio:
(EBITDA)
(Interest Expense + Certain Dividends)
The ratio is used as a gauge for the company’s ability to cover its financing expenses using operating earnings. Most covenants The ratio is used as a gauge for the company’s ability to cover its financing expenses using operating earnings. Most covenants specify that the FCC ratio remain above 2X, by far the most common limit, though this threshold can vary. Chart 4 takes new issues that have an explicit FCC covenant, and divides them into two buckets based on the stated limit: 2X or less (loose covenant) and more than 2X (tight covenant). The number of FCC covenants requiring a limit of more than 2X has diminished somewhat, a loosening covenant trend, but this has never comprised a large portion of new issues so we are not alarmed. As with most covenants, it is important to assess the FCC language cautiously. Items to watch out for include explicit secured debt carve-outs that effectively allow for additional bank debt incurrence and varying definitions of the FCC calculation.
Lien covenants are another mechanism to defend bondholders by restricting or limiting the amount of future debt that can be secured with company assets. This feature is intended to guard the bondholders place in the capital structure by ensuring the company does not incur future debt with greater seniority, or limits how much senior/secured debt it can issue going forward. Chart 5 divides all new senior issues (both secured and unsecured) into two buckets: those that contain an explicit lien covenant and those that do not. While there was a recent uptick in the number of issues that did not contain a lien covenant during the first quarter of 2014, this type of covenant has become increasingly pervasive in recent years—a tightening covenant trend.
Another type of negative covenant comes in the form of restricted payments. These covenants prevent or limit the company from using its cash for items like dividend payments, share repurchases, acquisitions, and other items generally considered to be unfavorable to bondholders. Rather than setting outflow limits for each possible use of cash, it is more common for a covenant to restrict the sum of these payments to some predetermined threshold (e.g. 50% of net income).
In recent years, some covenant packages included a provision that essentially removes limits on restricted payments, so long as a certain leverage ceiling is not exceeded. Chart 6 depicts new issues that have an explicit restricted payment covenant, highlighting those that have a provision for unlimited payments if some leverage requirement is met. On the surface, a leverage limit can be relatively restrictive so long as loopholes are limited—careful consideration of the restricted payment details is required to determine the true level of flexibility. Our view is that the increased prominence of this provision signifies a loosening covenant trend.
III.Change of Control Provisions
Most covenant packages that contain a change of control provision permit the bondholder/investor to put (i.e. sell) the bonds back to the issuer at 101% of par value. This covenant allows, but does not require investors to exit their investment when the underlying issuer experiences a change of control (typically when 50% or more of voting rights changes hands).
While change of control covenants are designed to benefit debt investors, some contain a provision known as a “double trigger”. This provision voids the put option unless the change of control is accompanied by a ratings downgrade; hence, the double trigger (change of control AND a ratings downgrade). Chart 7 depicts the prevalence of this feature in recent years. This “double trigger” provision has become increasingly popular—a loosening covenant trend.
IV.Other Interesting Trends
Chart 8 displays low rated (CCC) issuance in recent years, which is often viewed as a gauge for the aggressiveness of the new issue market. The proportion of CCC-rated bonds has increased over the past few years relative to BB and B-rated issues. Levels remain well below the pre-financial crisis peaks, but this is something we monitor with a cautious eye.
Chart 9 shows pay-in-kind (“PIK”) and PIK/toggle bonds as a percentage of total new issuance volume. As opposed to standard cash-pay bonds, these issues are permitted to make interest payments in the form of additional debt. PIK bonds generally make payments with additional debt while PIK/toggle bonds provide the option to pay with cash or additional debt. These issues became quite popular during the lax lending period leading up to the financial crisis, but have faded since—particularly as a percentage of total new issuance.
Conclusion
A highly conservative, bondholder-friendly covenant package cannot transform a bad credit into a good credit. Covenants, however, are an important risk control designed to safeguard investors from overly aggressive behaviors by management and/or equity shareholders. The idiosyncratic nature of covenants makes identifying broad trends challenging, but thanks to some diligent work by Xtract Research we have some broad information from which to draw meaningful inferences. Based on covenants that address redemption flexibility, covenant packages appear to becoming looser—primarily due to shorter non-call periods. Based on negative covenants designed to limit financial leverage, results are mixed. Basic leverage limitations appear to have remained constant or even more conservative, but we have witnessed an increase in certain loopholes. Change of control and other covenants also show some signs of loosening and some signs of tightening. Overall, we believe there are more loosening trend signals than tightening trend signals, but nothing alarming. We have always believed that each covenant package must be examined individually and in the context of other risk factors like asset coverage and capital structure seniority—though we hope these broad trends have provided some helpful context for the overall high yield market.
1 The universe (for all charts) consists of new issues that were currently outstanding as of March 2014. Bonds that have since been retired are excluded due to data availability.
Hotchkis & Wiley High Yield Research, with special thanks to Xtract Research (www.xtractresearch.com)
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Data source(s): charts 1-7: Xtract Research; Charts 8-9: JPMorgan.
Par value is the face value of a bond. EBITDA stands for earnings before interest, taxes, depreciation and amortization. Ratings are grades given to bonds that indicate their credit quality as determined by private independent rating services S&P, Moody’s or Fitch. These firms evaluate a bond issuer's financial strength, or its ability to pay a bond's principal and interest in a timely fashion. Ratings are expressed as letters ranging from 'AAA', which is the highest grade, to 'D', which is the lowest grade.
Investing in high yield securities is subject to certain risks including market, greater price volatility, credit, liquidity, issuer, interest-rate, inflation, and derivatives risks. Lower-rated and non-rated securities involve greater risk than higher-rated securities. Investment grade bonds, high yield bonds, and other asset classes have different risk profiles which should be considered when investing. High yield securities have greater price volatility and credit and liquidity risks (presenting a greater risk of loss to principal and interest) than other higher-rated securities. Historical interest rates are not indicative of future yield curves. Any discussion or view on a particular asset class or investment type are not investment recommendations, should not be assumed to be profitable, and are subject to change. Credit cycles vary in both length and volatility. Past credit cycles will differ from current or future cycles.
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