Throughout 2020, covenant quality will likely continue to weaken across the globe in a low yield environment. According to experts in the high yield space, issuers are expected to maintain the upper hand for as long as global interest rates remain low.
While covenants have been weakening at a global level for some time, their quality is deteriorating in North America more rapidly than in other parts of the world. According to research by Moody’s, the divergence – whereby restrictive covenants in Europe are more protective than North America – reflects a trend in North American investors’ willingness to sacrifice covenant protections for yield.
Sponsors will still be winners
In the US, sponsors will likely continue to influence covenant packages, negotiating ever-more favorable deals on behalf of issuers.
"This is a multi-year trend with expanded restricted payment builder baskets and changes to the way such baskets are calculated," said Jason Elder, partner at Mayer Brown. "There are several deals with no ratio requirement for use of the builder basket, a lack of default blockers and high day one restricted payment capacity, each of which create optimal leakage conditions from the credit group."
"Scalable grower baskets will likely win the day," said a US-based high yield lawyer. "While there is some investor pushback, sponsors have gained a lot of ground, and 2020 will be a year of sponsor victory."
Similar concerns are also present in Europe. "Portability is in nearly every sponsor deal, and new calculation flexibility has made it easier than ever for a sponsor to benefit from this provision," said Sabrina Fox, executive advisor at the European Leveraged Finance Association.
Portability provides for an exception to the change of control covenant that allows the equity of the issuer to be sold without requiring a change of control offer to be made.
Fox added that Europe is, in general, a more precedent-driven market than the US, which means that smaller deals often contain some of the same covenant flexibility as tier one sponsor deals.
More flexibility to incur debt
An interesting trend that Fox observes globally is that private equity sponsors are cycle-proofing their covenants so that they contain flexibility to pay dividends even when the company is in default – to ensure their investment can be de-risked ahead of the company becoming distressed.
"Private equity sponsors and their advisors have also embedded more flexibility to incur senior debt, and to make investments outside of the restricted group – features that will allow the private equity sponsor to navigate stressed scenarios more nimbly than would otherwise be the case, and potentially to the detriment of investors," said Fox.
Lack of transparency for investors
A worrying trend that Fox is seeing at a global level is that reporting obligations have become watered down so that investors are receiving less information, less frequently, and with less granularity that was previously the case.
"Calculation flexibility, including Ebitda add-backs, have imposed an almost impenetrable veneer over covenant capacity, making it nigh-on impossible for investors to ascertain the risk present in a covenant package at any given time," she said. "There is no contractual requirement that these calculations are made available to investors."
She added that provisions like net short lender disenfranchisement are beginning to slip in around the margins, raising the spectre of liquidity impediments down the line.
Carveouts expand in Asia
According to Jake Avayou, VP, senior covenant officer, corporate finance at Moody’s, certain Chinese issuers have also included language in their restricted payment carveouts not seen before in Asian bonds.
The language, which is common in North America, gives them greater flexibility to make restricted payments – for example, a dividend carveout that allows unused amounts to be carried over to the subsequent fiscal year.
The presence of priority debt carveouts for ratio debt continues to expand in Asia, reflecting an increase in the collateral being provided to structurally senior lenders in the credit structure. "These provisions can significantly impact bankruptcy or insolvency outcomes as the structurally senior secured debt will rank ahead of the offshore high yield notes," said Elder. "Structural subordination has always been a key issue for high yield debt from Asia, and it isn’t improved by the growing presence of priority debt carveouts."
Fredric Teng, head of high yield for greater China and north Asia at Standard Chartered Bank, added: "Investors are willing to accept further weakening of covenants because Asian covenants are still generally significantly tighter than their peers in Europe and the US. Some deals in the west, particularly those from sponsor-owned companies, are extremely aggressive."
Teng added that from a global emerging markets perspective, high yield bonds from greater China have been outperforming their counterparts and continue to offer better value than other parts of the world.
"The trend we have observed in the broader Asian market is a bifurcation in approach to covenant packages between Chinese and non-Chinese high yield issuances," said Paul Olivera, executive director at Morgan Stanley.
He said that for Chinese high yield, largely comprised lately of the real estate sector, covenant packages tend to be light as there is an expectation of implicit macro sovereign support.
In contrast, in greater southeast Asia, such as Indonesia, covenant packages tend to be much tighter as there is less anticipated government support, greater idiosyncratic issuer/sector risk, and a different investor pool. Investors in these jurisdictions tend to look much more closely at the underlying credit quality and the individual dynamics of an issuance.
This article first appeared in the International Financial Law Review, January 8th 2020.