Two years after suffering $213.2 billion of losses when debt markets froze, investors in junk bonds are accepting what Moody’s Investors Service calls the weakest creditor protections since 2007.
Even with housing starts hovering at their lowest levels on record, Beazer Homes USA Inc. (BZH) managed to sell bonds this month on terms that allow it to add more debt. The Atlanta-based builder couldn’t even do that when it issued debentures at the height of the housing bubble in 2006 and its credit rating was seven levels higher. In a report last week Moody’s singled out CF Industries Inc. (CF), Standard Pacific Corp. (SPF), AK Steel Corp. (AKS) as borrowers offering debt on terms historically available only to higher-rated companies.
“We got ourselves in trouble with that in the past and here it is again,” James Kochan, the chief fixed-income strategist at Wells Fargo Fund Management in Menomonee Falls, Wisconsin, said of the trend toward looser debt covenants. “It’s not that surprising, but it is disturbing,” said Kochan, who helps oversee $179 billion.
Lenders are letting down their guard just as worsening government finances raise doubts about the sustainability of the global economic recovery. Money managers say they have little choice but to go along. They need to find a home for the record $29.4 billion that has flowed into high-yield bond mutual funds the past 16 months from retail investors seeking to join in a rally that has produced an average 69 percent return since the market bottom in March 2009.
About 60 percent of high-yield borrowers this year offered weaker investor safeguards than on debt they issued previously, according to Covenant Review LLC, a New York-based research firm that analyzes bond offerings. Those include no limits on the amount of debt companies can have and few restrictions on using assets as collateral for future borrowing, reducing what’s available to satisfy creditor claims in a bankruptcy.
“This trend represents more than an episode of ‘back to the future,’” Moody’s analysts including Alex Dill, the firm’s senior covenant officer, wrote in their report. “It reflects a weakening in covenant protections even below those existing at the peak of the market, in 2006 and 2007.”
Beazer sold $300 million of 9.125 percent bonds due in 2018 on May 4 that carry lighter restrictions than its 2006 issue on the amount of debt the builder can add and how it can use money raised from selling assets. The terms also allow Beazer to double its capacity to pay dividends to shareholders even after a 90 percent drop in its stock, according to Covenant Review.
The company’s senior unsecured bonds are rated Caa2, which Moody’s defines as “judged to be of poor standing and are subject to very high credit risk.” Beazer was rated Ba1, one step below investment grade, in June 2006, when it issued $275 million of 8.125 percent 10-year notes.
Jeffrey Hoza, a vice president and treasurer of Beazer, and Chief Financial Officer Allan Merrill didn’t return calls seeking comment. Junk bonds are rated below Baa3 by Moody’s and less than BBB- by Standard & Poor’s.
Overseas Shipholding Group Inc., the largest U.S.-based oil-tanker owner, sold $300 million of bonds in March, its first offering in six years. Debtholders gave the company the leeway to sell assets, new secured debt and pay dividends to equity holders, according to Covenant Review. The bonds, due in 2018, are rated Ba3 by Moody’s and an equivalent BB- by S&P.
“We were not going to do a deal if we were not able to get that kind of flexibility,” said Morten Arntzen, the chief executive officer of the New York-based company. “We had no resistance to it” from potential investors, he said. Proceeds from the sale were used to repay debt under a revolving credit facility, the company said in a March 29 statement.
Overseas Shipholding’s covenants are “nearly useless,” according to Covenant Review. Investors bid up the debt anyway, pushing the 8.125 percent notes to as high as 102.25 cents on the dollar last month, according to Trace, the Financial Industry Regulatory Authority’s bond-price reporting system.
“They’re a high-yield issuer that’s getting away with investment-grade covenants,” said Adam Cohen, founder of Covenant Review. “You shouldn’t have a high-yield bond that gives you less protection than a lot of the high-grade bonds out there.”
Cash is flowing into mutual funds that specialize in high-yield debt at an accelerating pace. EPFR Global, a research firm in Cambridge, Massachusetts, estimates that before last week, investors put $8.57 billion into the funds, up from $7.33 billion in the same period of 2009.
That money helped push down yields on speculative-grade bonds to 8.23 percent on April 27, the lowest since July 2007, from 21 percent in March 2009, Bank of America Merrill Lynch indexes show. Yields averaged 8.77 percent as of yesterday.
Borrowers are taking advantage of the demand, issuing $109.1 billion of debt this year, compared with the record $162.7 billion in all of 2009, data compiled by Bloomberg show.
Investors are also snapping up junk bonds as Federal Reserve (FDTR) policy makers pledge to hold interest rates near zero for an “extended period” to stoke the economy. Of the 460 companies in the S&P 500 that reported first-quarter results, 77 percent said earnings exceeded analysts’ estimates, Bloomberg data show.
Gross domestic product may expand 3.2 percent this year, after contracting 2.4 percent in 2009, according to the median estimate of 72 economists surveyed by Bloomberg. Housing starts climbed to an annual rate of 626,000 in March, up 1.6 percent from February’s 616,000 pace, though still half the level from October 2007, according to Commerce Department data.
For all the concern about weaker creditor protections, Moody’s has raised the ratings on 156 junk-rated companies this year and lowered 111, based on data compiled by Bloomberg. The 1.41-to-1 ratio is the highest for any two-quarter period since at least 1999. S&P said last week the corporate default rate for speculative-grade-rated borrowers was 0.97 percent at the end of the first quarter.
Relative yields that are high by historical measures offer some protection from loose covenants, according to Richard Inzunza, a money manager at Northern Trust Global Investments in Chicago, with $647 billion of assets. Junk-bond spreads average 6.36 percentage points, compared with the record low of 2.41 percentage points in June 2007, based on Bank of America Merrill Lynch indexes.
“There are some deals that may have weaker covenants but we think we’re getting paid enough to participate in the issue,” said Inzunza, whose firm owns bonds of Overseas Shipholding.
Martin Fridson, the chief executive officer of New York-based money manager Fridson Investment Advisors, said the loosening of covenants isn’t at a level yet that would signal the end of the bull market in junk bonds.
Covenants are typically strengthened following periods in which high-yield issuers are blocked from the market, “and at the end of that cycle, there’s an ‘anything goes’ mentality,” said Fridson, 57, who was Merrill Lynch’s head high-yield strategist before leaving to form his own firm in 2002. “We haven’t reached that final stage.”
Cracks in the junk bond rally are emerging on speculation that rising budget deficits in European countries such as Greece, Spain and Portugal may cause lawmakers to curb spending, slowing the global economy.
High-yield bonds in the U.S. have lost 2 percent this month, according to Bank of America Merrill Lynch index data. This would be the first down month since February 2009, when they fell 3.47 percent.
CF Industries, the Deerfield, Illinois-based fertilizer maker, sold $1.6 billion of bonds on April 20, before the upheaval. The debt doesn’t restrict liens on the company’s property, plants and equipment worth less than 1 percent of its assets or located outside the U.S., according to Moody’s. Previously, covenants typically had tougher restrictions that affected property worldwide.
That could allow CF to use the property as security for future borrowings, reducing what’s available to pay investors in the notes in a default, according to Dill.
Terry Huch, a CF spokesman, declined to comment.
The loosened provision, typically used by investment-grade borrowers, first began appearing in debt sold this year, Dill said. It was included in $400 million of securities offered last month by West Chester, Ohio-based AK Steel, the third-largest maker of the metal by sales after Nucor Corp. of Charlotte, North Carolina, and Pittsburgh-based United States Steel Corp., according to Dill.
‘Like a Meme’
“Once you get a structure into the market, it replicates itself like a meme and it survives because the investors keep buying it,” Dill said.
Rising demand for junk bonds has also allowed companies emerging from bankruptcy, including Houston-based Lyondell Chemical Co., which sold $2.75 billion of debt in dollars and euros on March 24 and Lear Corp. (LEA) of Southfield, Michigan, which issued $700 million of notes on March 23, to borrow with few restrictions, Covenant Review’s Cohen said.
Lyondell’s covenants offer no clear limits on the amount of additional secured debt the company can sell and permit it to shift as much as $1.25 billion of assets to units that aren’t covered by the bonds’ limitations, reducing the collateral available to creditors, according to a Covenant Review report.
“In 2008, all the companies that we said would screw the bondholders did it,” said Cohen of Covenant Review. “Now, it feels like 2007 to me. We’re telling them they’re going to get screwed and they’re not paying attention.”
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