Ignoring risk, investors still buying US junk debt with weak protections

When US-based construction material supplier Wilsonart issued a junk bond to raise $500 million to fund an acquisition this summer, a research firm warned potential investors that the terms of the deal offered them weak protections.

The bond’s covenants would allow the company to potentially move valuable assets to a different entity later and raise even more money, putting the investors in the bond at a disadvantage, the research firm, Covenant Review, wrote in a review seen by Reuters.

The warning came against the backdrop of growing worries in credit markets after an increasing number of companies have used similar weaknesses to borrow more against the same assets, in a practice euphemistically called a liability management exercise.

That has favored some creditors over others, a result that’s come to be known as creditor-on-creditor violence. Things have become so bad this year that some creditors have been banding together to fight back.

So, what did investors do in the case of the Wilsonart offering after the warning? They lapped it up.

Wilsonart did not respond immediately to a request for comment.

Wilsonart’s ability to raise the money highlights a paradoxical trend in US credit markets: while investors are suffering the consequences of weak covenants, they are letting a vast majority of companies sell them new paper with the same flaws without significant pushback, credit market bankers, lawyers and investors said.

The reason, these market sources said, is lack of enough supply of junk-rated bonds and the need to lock in higher yields before the Fed begins to cut interest rates as well as diverging interests between the biggest creditors and small investors.

“Investors have a tough choice to make: Do I sit in cash and not buy a bond or loan because of looser documentation and thereby risk hitting my return hurdles,” said Peter Toal, global head of fixed income syndicate at Barclays. Toal said the lack of supply was in part because most of the borrowing now has been to refinance old debt.

Several bankers and analysts estimated 90 per cent of high-yield bonds and loans that are coming to the market now are being sold with weak investor protections despite growing concern that stressed companies were taking advantage of them to raise fresh funds to repay maturing debt or simply remain solvent.

More than 90 per cent of the Morningstar LSTA Leveraged Loan Index is now “covenant-lite” or lacking maintenance covenants, a metric that has increased sharply since the financial crisis of 2008, a Barclays research report shows.

Liability management exercises (LMEs) come in many forms, but the most common tactic is for the company to transfer valuable assets into a subsidiary. That subsidiary then raises debt in a side deal from some old and new investors. The cash is then forwarded back to the parent as an intercompany loan.

The side deal gives the new creditors a priority claim on the company’s assets in case of a bankruptcy, pushing existing investors down the line, increasing their potential losses in the event of default.

High-yield bonds and loans bought by investors make their way into funds that are then sold to retail and large institutional investors who, as a result of weaker covenant protections and covert LMEs, may end up facing losses or underperformance of their investments.

Distressed exchanges

So far in 2024, 28 companies have completed a distressed exchange, totaling $35 billion, the second-largest total on record, according to JPMorgan. Their numbers are expected to only grow.

“A vast majority of bonds and loans have no guardrails against LMEs, and they are easily sold,” Josefsberg said.