Flirting With Danger

Junk Bonds Work Without a Net

High-yield bonds have fewer protections and pay less cushion.
Photographer: John Harrelson/Getty Images for NASCAR

Over the past eight years, junk-rated corporate debt has been transformed from a fringe asset to a staple for many fixed-income investors.

As they've become more popular, these risky bonds and loans have increasingly lost a feature that made them so attractive (and lucrative) -- the investor protections known as covenants written into the documents that govern the debt. These are aimed at ensuring investors can recover their money if the company fails.

Last month, the $26.9 billion of junk bonds sold had the highest proportion of deals on record with weak investor protections, Moody’s Investors Service reported this week. About 60 percent of the risky U.S. corporate bonds sold last month had few protections written into their deal documents, Moody's said. 1

Debt Deterioration

The quality of investor protections on U.S. high-yield bonds has been deteriorating

Source: Moody's High Yield Covenant Database

In the leveraged-loan market, nearly three-quarters of the debt is "covenant lite" after three years of record issuance, Moody's noted in May.

That means a growing number of bond and loan investors are forfeiting their right to prevent companies from, say, borrowing a lot more money or making big investments that lenders may view as imprudent.

This weakening is emblematic of a continuing shift in the junk-debt market. Investors have grown so confident about the seemingly interminable corporate-debt rally that many are dismissing the likelihood of large swaths of risky companies going bankrupt. After all, these covenants usually don't matter until there's a problem.

Lower Recoveries

Bonds of private-equity owned bankrupt companies tend to have lower recoveries than others

Source: Moody's Investors Service

Private-equity sponsors are generally better able to negotiate borrower-friendly covenants and provisions as they tend to be in the market more often, according to Moody's

There have been many warnings about the dangerous complacency settling into markets, and there's no need to repeat them here. Nor are looser covenants a sign of imminent doomsday. But weaker protections translate into lower investor recoveries should a company go bankrupt. And this reality isn't being baked into the market. High-yield bonds of companies outside of the energy industry are paying close to the smallest cushion of extra yield over benchmark rates in the post-crisis era.

Spread Squeeze

Investors are earning about the least to own top-rated junk bonds since 2007

Source: Bloomberg Barclays indexes

The top-rated junk bonds, which have a greater likelihood of having weaker covenants 2 , are offering even less relative to their history, with the least extra yield over benchmarks since 2007. So even as investors buy a disproportionate amount of bonds with BB tier ratings, they're giving up more control should those borrowers run into trouble.

The consequences of this may not be seen for years to come, although there's a decent likelihood of a recession in the not-so-distant future. But investors who are diving into junk debt with relatively few protections should be aware that the downside may be much greater than in the past, with bigger potential losses and greater price swings. Because that's what happens when companies are freer to make bad decisions that leave them with few assets left to liquidate and less money to repay creditors. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
  1. June's junk-bond issuance was dominated by top-rated high-yield bonds as well as those sold by private-equity backed companies; both categories tend to have looser covenants.

  2. Investment-grade bonds tend to have relatively few covenants, and higher-rated junk bonds are increasingly treated similarly to their better-rated brethren. 

To contact the author of this story:
Lisa Abramowicz in New York at

To contact the editor responsible for this story:
Daniel Niemi at

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