Haven or hell?

The buoyant high yield markets continue to lure yield-hungry investors, as well as sponsors rushing to (re)finance deals. But now, as a result of the boom, covenant quality is at a record low.  

Another week, another private equity firm turns to the high yield bond market to refinance an asset.

LBO France’s decision to use the bond market to refinance portfolio company Labeyrie earlier this week was the latest example of a significant trend. The heavily oversubscribed bond issuance – LBO France partner Thomas Boulman said appetite for the bond outstripped its actual size by 15x – enabled the firm to both tidy up Labeyrie’s capital structure through repaying outstanding senior debt and convertible bonds, and pay its investors a healthy dividend.

At a briefing held by a prominent private equity firm this week at which a senior leveraged finance banker also spoke, the high yield market featured prominently in the discussion. The European market has changed drastically over the last decade, with bonds issuance now regularly outstripping loans as was the case in every year since 2009 bar 2011. “Back in 2007 the European high yield market in Europe was very unsophisticated and very shallow. Now it has a real following, real depth,” one participant observed.

As a refinancing tool, junk bonds are popular because they allow a sponsor to both improve a company’s capital stack whilst locking in low, long-term fixed interest rates. For a sponsor eyeing an exit via IPO in due course, they also have the ancillary advantage of preparing the management team for that process (given the requirement to draw up a prospectus, roadshow the bond, and then post-issue engage with the analyst community).

Investors have ploughed headlong into high yield markets over the last 12 months, driven by the impact of low interest rates on government bond yields. That in turn has led to yield falling spreads as demand exceeds supply.

Those who forecast the demise of the high yield bond market on the back of those plummeting yields last year may have been proven premature, but not all is sweetness and light.

Moody’s this week revealed North American high yield bond covenant quality had fallen to a record low in February. The ratings agency attaches a covenant quality score to each bond it looks at, on a scale from 1.0 (strongest investor protection) to 5.0 (adrenaline junkie investors only need apply). The average score in February was 4.36, the lowest since the company began tracking covenant quality in late 2011. A lack of debt incurrence and/or restricted payments covenants were to blame, according to Moody’s.

Lower quality issuers are also coming to market, tapping demand which in a more normalised interest rate environment would not exist for riskier credits. Some issuers are also nudging the boundaries of what’s considered an acceptable bond issuance downwards, with smaller bonds (beneath the generally accepted minimum of $200 million) increasingly prevalent. Smaller bonds are, the theory goes, much less liquid, and therefore increase risk further.

The advice for investors then is: due diligence the issuer’s creditworthiness carefully, make sure you’re not trading away protections for a few extra basis points of yield, and manage your exposure.

Meanwhile, non-bank lenders focused on extending loan-based credit must be wondering what on earth is going on. High yield represents an alternative to the debt such funds can provide. But patience will no doubt be rewarded. As interest rates rise the high yield market is bound to contract – just look at what happened in the US last year after the Fed simply suggested it might begin tapering its QE programme.

And for all their many advantages, high yield bonds can be a time-consuming and resource-intensive business, which sponsors are sometimes unwilling to stomach (witness the growing popularity of unitranche). Private equity groups are a secretive bunch too, and the disclosure requirements for a high yield issue therefore sit uneasily with some firms. Far better, in that case, to go down the loan route with a like-minded private debt fund.

On the acquisition finance front, loan packages are still in many cases the default option, with high yield a consideration as a useful source of additional leverage but seldom the preferred option. But even with this caveat, it’s clear that the importance of the high yield market cannot be ignored. For the time being, this is still a party few seem willing to quit just yet. 

PS: PDI will next week publish Understanding High Yield Bonds, a guide to the drafting, offering and interpretation of contemporary bond covenants. For more detail, and to order a copy, click HERE