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Covenant Arbitrage Exploited in High-Yield Bonds: Credit Markets

Covenant Arbitrage Exploited in High-Yield Bonds
Investors began pushing up the price of Chesapeake’s 2019 notes last month to take advantage of “sloppy” language in the deal documents, according to Covenant Review’s Cohen. Photographer: Daniel Acker/Bloomberg

The hundreds of pages of tedious documents that govern every corporate bond sold are suddenly a hot commodity as traders look for an edge with the biggest bull market ever in junk debt slowing.

Chesapeake Energy Corp.’s $1.3 billion of 6.775 percent notes climbed to a record 104.5 cents on the dollar in a wager that the natural gas producer has run out of time to repurchase the debt at par, or 100 cents, as allowed by the debt’s covenants. Plano, Texas-based J.C. Penney Co.’s 7.125 percent notes due 2023 have risen 9 percent this month, even as the rest of its debt plummets, in a bet the retailer will be forced to repay the issue early because of a covenant breach.

High-yield, high-risk bonds are posting their worst start to a year since 2009 after returns soared more than 118 percent from the end of 2008 through December. Now, an increasing number of investors are being forced to take advantage of little-noticed provisions in deal documents to gain an edge, according to Adam Cohen, the founder of Covenant Review, an independent research firm in New York.

At this phase in the credit cycle, “you have to be a manager that truly understands what’s happening and why,” Matthew Duch, who helps manage $12 billion in assets at Calvert Investments Inc. in Bethesda, Maryland, said in a telephone interview. “You’re going to have to avoid blowups and understand the credits and the prospectuses much more closely than in the past of buying and just holding.”

‘Sloppy’ Language

Investors began pushing up the price of Chesapeake’s 2019 notes last month to take advantage of “sloppy” language in the deal documents, according to Covenant Review’s Cohen. Those securities rose above par even though the bond covenant has a redemption provision based on a March 15 date. The debt has since declined to 103.5 cents.

Some traders believe that the company is wrong that it can redeem the notes at par and that Chesapeake would have to pay a substantial premium if it wanted to repurchase them, Cohen said. If a so-called make-whole call provision were triggered, the company would have to pay bondholders as much $400 million in addition to the principal amount of the notes.

“The value of litigating the position may be high enough to make a little legal spending on a narrow issue worthwhile,” Cohen wrote in a March 1 report. “Hiring a law firm to challenge the narrow issue of a par call would be relatively inexpensive.”

Jim Gipson, a spokesman for Oklahoma City-based Chesapeake, said he couldn’t immediately comment.

Corporate Takeovers

The lowest borrowing rates on record engineered by the Federal Reserve have helped propel $86.6 billion of corporate takeovers in the U.S. in February, the busiest month since July 2008, according to data compiled by Bloomberg. Investors are poring over deal documents to determine the consequences of corporate actions on outstanding bonds and whether any provisions haven’t been exploited by the market, Cohen said.

“Indenture plays heat up during two periods: high mergers-and-acquisitions activity and high levels of distress,” Cohen said yesterday in an e-mail. “The past three months have been hot.”

Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. fell, with the Markit CDX North American Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, decreasing 0.5 basis point to a mid-price of 83.2 basis points as of 11:29 a.m. in New York, according to prices compiled by Bloomberg.

Rate Swaps

The index, which ended March 5 at the lowest level since Sept. 14, typically falls as investor confidence improves and rises as it deteriorates. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The U.S. two-year interest-rate swap spread, a measure of debt market stress rose from a seven-week low, increasing 0.61 basis point to 14.05 basis points as of 11:26 a.m. in New York. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as company debentures.

GE Bonds

Bonds of Fairfield, Connecticut-based General Electric Co. are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 4.6 percent of the volume of dealer trades of $1 million or more, at 11:25 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Average returns on junk bonds have slowed to 2.2 percent this year, the least for the period since a 1.7 percent loss in 2009, according to the Bank of America Merrill Lynch U.S. High Yield index. The debt gained 15.6 percent in 2012.

The extra yield investors demand to hold the securities rather than government debt has contracted by 13.2 percentage points since the end of 2008 to 4.88 percentage points as the Fed’s bond-purchasing program and policy of holding benchmark borrowing rates between zero and 0.25 percent enter a fifth year.

Junk notes will likely gain 3.1 percent this year, with a worst-case scenario of a 4.8 percent decline and maximum of 5.6 percent returns, Morgan Stanley credit strategists Adam Richmond and Jason Ng in New York wrote in a report published Dec. 4. The base case would be the least since the 26 percent loss for the notes four years ago.

‘Home Run’

High-yield or junk debt is rated below Baa3 by Moody’s Investors Service and lower than BBB- at Standard & Poor’s.

Investors have set their sights on J.C. Penney debt after its $552 million fourth-quarter loss, the retailer’s worst performance since 2004, which is leading analysts from CreditSights Inc. to S&P to predict it may have to draw down on a $1.85 billion revolving credit facility to fund operations.

Holders of the company’s $254.5 million of 7.125 percent bonds are wagering that such an action may cause the retailer to breach a restriction, forcing it to buy back the notes at a premium to their current price, Cohen said. He wrote in a Feb. 13 report that he thought such an outcome was unlikely.

“If you think it can’t be breached, the yield for those bonds should be in line with all the other J.C. Penney bonds,” Cohen said in an interview.

The notes, which traded as low as 83 cents Jan. 15, increased to 94.25 cents yesterday to yield 7.93 percent, Trace data show. That’s higher than the 76.6-cent weighted average of J.C. Penney’s five biggest bonds, Bloomberg data show.

Joey Thomas, a spokesman for J.C. Penney, didn’t immediately respond to a telephone call seeking comment.

“There are funds that spend a lot of time looking at bond covenants to see if there are any mistakes or breaches,” Salvatore Naro, chief executive officer of New York-based Coherence Capital Partners LLC, which manages $100 million, said in a telephone interview. “If it works out, obviously you hit a home run.”

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