America’s high yield bonds are on increasingly shaky foundations
INVESTORS IN COMPANIES The issuance of high yield bonds, or “junk” bonds, has had a relatively harmless pandemic. Typically, those borrowers with high leverage are stung by economic difficulties. During the global financial crisis over a decade ago, about a seventh of these companies in America went bankrupt on their debts within a year. However, according to Moody’s, a rating agency, less than 9% of them were in default by August 2020, and the rate has continued to fall since then. A booming recovery should bring it back below its long-term average of 4.7% by the end of 2021
However, it may be too early for high yield investors to congratulate themselves. The low failure rate hides a market that is much riskier than it was before the Covid-19 outbreak. Take high yield bonds, whose market is worth $ 1.7 trillion. Issuers have record levels of leverage relative to their earnings, making them more vulnerable to higher interest rates or a disappointing economic recovery. Borrowers struggling with liquidity use less restrictive loan agreements to shake up their creditors. And for the insolvent companies, loans that used to be associated with a high level of protection and security prove to be anything but anything else.
Start with the sheer amount of debt. Last year junk bonds worth $ 435 billion were issued. As a result, the average high-yield borrower now has debt equal to an unprecedented six and a half times the past 12 months’ gross operating profit, or EBITDA (see grafic). Bank of America’s Oleg Melentyev warns that the low failure rate may have only delayed the pain. “Companies carry the baggage of capital structures that were supposed to be restructured but weren’t,” he says. “We will pay the price of increased defaults later in the cycle.”
Meanwhile, borrowers with liquidity problems have the upper hand over their lenders. Moody’s Evan Friedman and Enam Hoque describe how investor thirst for returns has eased loan contracts during more than a decade of low interest rates. Maintenance covenants or restrictive clauses that allow lenders to take the reins in hand if the borrower’s financial situation worsens are mostly missing today. Worse still, incurrence covenants, which limit borrowers’ ability to issue new debt and pay dividends, have dwindled over time. “If you move to Covenant-Lite and get your Incursence Covenants toothless, you give the borrower the flexibility to run the show,” Friedman says.
Some of them are running. Serta Simmons Bedding, a mattress maker, gained fame last year for borrowing $ 200 million by exchanging its debts with some lenders for new ones with a higher level of security. Without their consent, the non-participating creditors were exposed to higher losses in the event of default. A lawsuit to reverse the transaction was dismissed by the courts, paving the way for similar deals in the future.
What happens to loans that go sour? Lenders are used to the notion that in the event of bankruptcy they will be given priority over the assets of the borrower. However, Moody’s analysis of defaults during the pandemic shows that first-lien lenders are losing almost twice as much of their capital as they used to: the average recovery rate in 2020 was 55%, compared to a long-term average of 77%.
This is the result of deteriorating debt structures, another decade-long trend. In the past, first-lien loans had high recovery rates because a significant part of the remaining debt was subordinate, i.e. stood behind them in the queue in the event of a default. But in 2020, over a third of first lien loans were not subordinated debt to absorb losses. When all of a borrower’s debts have an initial claim on their property, the value of that debt is lower and lenders lose more protection.
None of this necessarily means America’s high yield market is headed for disaster. Interest rates remain low and a quick recovery should restore earnings. But a nasty surprise on both fronts could quickly lead to trouble. The standard Covid-19 cycle may still have a sting in its tail. ■
This article appeared in the Finance & Economics section of the print edition under the heading “The Junk Heap”