Those who traded credit in the frothy days of 2007 will recall that virtually every piece of new paper, including LBO debt, would come to market with the skimpiest of creditor protections, i.e., “covenant lite” which to many was an indication that money was literally being thrown without any discrimination in the last epic chase for yield, just as many were preparing for the imminent market backlash. Which they got shortly thereafter. Judging by the amount of covenant lite loans issued in 2012 as a percentage of total and compiled by Brandywine Management, which just surpassed the credit bubble frenzy of 2007 at more than 30% of total issuance, the bubble in credit is now well and truly back – a job well done Federal Reserve, just 5 years after the last credit bubble.
And that’s just for loans.
A quick look at high yield bond space shows exactly the same, with Moody’s reporting that the covenant quality of North American high-yield bonds continued to slide in January, and has hit a new low in the month of January.
Moody’s Investors Service says in its second monthly report on its recently launched Covenant Quality Index (CQI). The index shows that covenant quality began to erode last July, at the same time that high-yield bond issuance started to climb.
“Our three-month rolling average CQI deteriorated to 3.89 in January from 3.79 in December,” says Alexander Dill, Head of Covenant Research at Moody’s and author of “Bond Covenant Quality Resumes Slide.” “The single-month score for January was 4.08, a marked deterioration from 3.55 in December and the previous low of 4.06 in November.”
The CQI uses a five-point scale, with 1.0 representing the strongest covenant protections and 5.0, the weakest. It peaked at 3.40 last July.
But investors are not being compensated for accepting weaker covenants, Dill says. “While investors are taking on more covenant risk, average spreads to benchmark yields have tightened, fueled by strong demand and a record volume of issuance.” Indeed, the average benchmark spread of bonds in Moody’s High-Yield Covenant issued since October is close to the level seen in the first half of 2011, though the CQI shows much weaker covenants.
Last month’s decline can be explained largely by an increase in high-yield-lite issuance. High-yield lite covenant packages, which lack a restricted payments and/or a debt-incurrence covenant, accounted for 34.6% of issuance in January, compared with 3.2% in December. Continuing a recent trend to convert to high-yield lite from full high-yield covenant packages, Netflix, Lear and Crown Americas all issued bonds with high-yield lite packages last month.
January also saw a higher percentage of bonds rated Ba, which generally have high-yield-lite covenant packages or full covenant packages with low covenant quality. These accounted for 58% of issuance in January, compared with the average of 27% since Moody’s began tracking the CQI in January 2011.
Luckily, just like in 2007, there is no risk at all of overheating: after all the Fed has a tremendous track record of intercepting bubbles in the credit, housing, and “stocks with an N/M PE multiple” asset classes. Surely they will deal with this one promptly and resolutely.