Bond Traders Plot Response as Safeguards Vanish
Junk bond investors have had enough of borrowers in Europe eroding safeguards as sales of the high-yield, high-risk debt surge to a record $110 billion.
Representatives from at least six firms met in London last week with the Association for Financial Markets in Europe to discuss reinforcing language in documents governing bond sales that protect investors, according to Gary Simmons, director of the group’s high-yield division. Legal & General Investment Management, Castle Hill Asset Management and Pioneer Investments are among money managers listed as members, according to AFME.
Bondholders are seeking to challenge private-equity firms and bankers who arrange debt sales about changes to terms, including shortening the time during which securities can’t be repaid and diluting change of control clauses protecting bondholders in a takeover. The weakening of covenants has drawn warnings from policy makers, with Federal Reserve Chair Janet Yellen saying last month she was concerned about “reach-for-yield behavior.”
“In a hot market, pricing can get tighter but safeguards such as call protection and change of control should stay the same,” said Henry Craik-White, a senior investment analyst at ECM Asset Management who attended AFME’s meeting. “The correct approach is to reach out to the wider investor community and highlight the issues before they ruin the market for everybody.”
AFME investors, who wrote to bond syndicate desks in 2011 highlighting the lack of disclosure in the high-yield market, may do the same now about the weakening of investor protection, according to Simmons.
Investor protection is also diminishing in the U.S. where a measure of the strength of junk-bond covenants is about the weakest since Moody’s Investors Service started tracking the data in 2011. In May, Clear Channel Communications Inc., the radio broadcaster with a credit rating that implies default, was able to more than double its offering to $850 million.
Companies are reducing safeguards as they take advantage of record-low funding costs and investor demand for higher-yielding securities. That’s fueling concern that complacency induced by six years of unprecedented stimulus from central banks around the world is increasing chances for future market instability.
“An excessive search for yield, which from a financial stability perspective, could make bond markets highly vulnerable to a repricing of risk stemming from the still fragile economic recovery and a normalization of U.S. monetary policy,” the European Central Bank said in its financial stability review in May.
Even as policy makers warn of the dangers and bond investors rail against the easing of covenants, demand for the riskiest debt shows little sign of diminishing. The yield premium bondholders demand to buy junk debt rather than investment-grade notes is approaching the lowest in seven years at 2.3 percentage points, according Bank of America Corp. data. That compares with 18.3 percentage points in December 2008.
Investors can resolve concerns about bond covenants simply by refusing to buy securities that don’t carry enough protection, according to Martin Reeves, the London-based head of high yield at Legal & General Investment Management, which oversees more than $700 billion globally.
“At the start of this year we switched from buying a lot of primary issues to being very selective and looking more at the secondary market,” said Reeves, who said he wasn’t at the AFME meeting.
Investor confidence is being buoyed by ECB plans to hand banks more than 700 billion euros ($947 billion) of cheap funding. Standard & Poor’s forecasts that the region’s corporate default rate may decline to 4.1 percent next year from 6 percent at the end of 2013.
Average protected non-call periods, where the issuer can’t redeem its callable bond before a certain date, have fallen from 3.7 years in 2009 to 2.6 years, data compiled by Bloomberg show. Investors are pushing back on the shortening of non-call periods because they restrict the amount a bond can climb in value and increase the risk bondholders will have to reinvest the proceeds at lower rates in the event of redemption.
Italian fashion brand Twin Set-Simona Barbieri SpA had to increase the period during which it won’t redeem its debt to 1.5 years from one year before it sold 150 million euros of floating-rate notes on July 15. The company, owned by Washington-based private equity firm Carlyle Group LP, planned to use some of the proceeds to pay a shareholder dividend.
“The most egregious weakening of terms is non-call erosion,” said ECM’s Craik-White. “Investors should share in the upside as the business delevers, rather than being constrained by a short call date, limiting how much the bond can trade up.”
DebtXplained, a London-based firm of legal analysts, calculates that 43 percent of the high-yield, high-risk deals it assessed this year include so-called portability clauses, which water down bondholder protection when borrowers get taken over. That compounds last year’s rate and is up from 14 percent in the same period of 2012.
The clauses may erase bondholders’ redemption rights after a takeover, negating change of control covenants designed to repay investors, typically at 101 percent of face value, when a borrower’s ownership changes.
Selecta Group BV, the Swiss vending machine company owned by Allianz Capital Partners, sold the equivalent of about 550 million euros of notes last month in a deal co-managed by KKR & Co. LP to refinance debt. The deal included a portability clause that exempts the borrower from calling the security in the event of a takeover if the debt-to-earnings ratio is sufficiently low, according to DebtXplained.
“It’s important for the market that the buy side and sell side are able to resolve issues like this and are not seen as diametrically opposed or on different sides of such important issues,” said AFME’s Simmons.
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