The cost to an issuer of ditching covenants on high yield bonds has fallen to a mere 10 basis points, according to research by junk market veteran Marty Fridson. The scramble for yield by investors that pushed the junk market to record issuance last year has made them indiscriminate about what they buy – hence the return of PIK toggles and other types of high-risk vehicles.
Covenant deterioration accelerated markedly in 2013. Moody’s publishes a covenant quality scoring criteria, which uses a five-point scale from 1.0 for the strongest investor protections to 5.0 for the weakest. The rating firm reported late last year that the average covenant quality score for the 12 months ended September was 3.64, compared with 3.41 in the prior 12-month period. For September alone it was 4.05, breaking the previous monthly record of 3.97 set in March.
The usual suspects – leisure, lodging and entertainment, home building and metals and mining – saw the biggest drops in covenant quality. Also, it made little difference if the company was owned by private equity – all types of issuers are now able to forego covenants with little push back from investors.
Mr. Fridson estimated last year that almost $1.6 trillion of junk bonds will default globally between 2016 and 2020, pushing current single-digit default rates upwards of 30 percent.