Homebuilders Offer Weakest Junk-Bond Protection, Moody’s Saysby
‘High-yield lite’ prevails at 70% in North American sector
Investors buy anyway, in part because land doesn’t depreciate
Junk bonds issued by homebuilders offer the weakest covenant protections of any non-financial sector in North America, but investors are buying anyway because land is viewed as such a strong underlying asset, Moody’s Investors Service said.
High-yield homebuilding bonds are three times more likely to carry the looser restrictions that are usually granted to investment-grade borrowers, according to a Moody’s July 14 report. Seventy percent of the sector’s bonds are governed by such “high yield-lite” features, compared with just 23 percent of all bonds in North America, Moody’s said.
“Even though most bonds are unsecured, the large amount of inventory, including land and work in process, on homebuilders’ balance sheets provides comfort to bondholders,” Moody’s Analyst Danny Gao wrote in the report. The reason, he said: “Land does not become obsolete and there’s a limited amount.”
Less protection for junk bonds is becoming more common as near-zero rates on conventional securities spurs demand for U.S. high-yield debt, putting issuers at an advantage. Covenant quality for all high-yield bonds fell the most on record in May and high-yield lite bonds became more prominent, according to a separate Moody’s report in June.
Stronger covenants can restrict a borrower’s ability to take on new debt or pledge collateral to someone else in a way that impacts the original lenders. Some entitle lenders to demand repayment if the company’s operating results or financial condition deteriorates.
In the case of many high-yield lite homebuilders, the underlying land assets do benefit the company’s overall creditworthiness, but in most cases there are no restrictions on the company’s ability to pledge those assets in favor of other creditors. The bonds offer weak protections against lien subordinations because they exempt much of the company’s inventory including land, according to Gao’s report.
“The absence of a debt restriction, combined with an ability to pledge inventory as collateral without triggering the equal and ratable clause, could materially weaken the unsecured bondholder’s position as a senior creditor,” Gao wrote.
Gao wrote that investors tolerate high yield-lite covenants in this sector because they’re offered by companies that Moody’s says rank among the industry’s largest, most profitable or most financially conservative, such as D.R. Horton Inc., Lennar Corp. and Toll Brothers.