Tensions Over Junk Bond Covenants Start To Boil Over

Robert Smith


When European bond investors tired of private equity firms and the law firms they employ watering down key protections in junk-rated debt, they turned to the Association for Financial Markets in Europe.

Influential asset managers such as AllianceBernstein and Schroders wrote a public letter to the board of AFME’s high-yield division — the closest thing the $400bn European junk bond market has to an industry trade body — expressing their dismay. These investor members of AFME took particular aim at the deteriorating quality of covenants — important clauses that restrict companies from taking reckless actions such as raising too much debt.

That was in 2015. Today the quality of these covenants in a market tapped by the likes of French telecoms conglomerate Altice and UK sports car maker Aston Martin is even worse. Asset managers such as pension funds are worried that whittling away these safeguards will leave them more exposed to losses when the credit cycle turns. And in a sign of the tensions straining the market, these asset managers are leaving AFME’s high-yield division in droves.

Mainly funded by banks and law firms, the industry trade body had previously let investors join free of charge in order to foster a dialogue with the buyers of the debt. But after AFME said in October that would it start charging membership fees to investors, the majority of high-yield investors are exiting, according to people familiar with the matter.

The new £7,500 annual fee for investment firms is a fraction of the amount charged to banks and law firms, but several investors told the FT that they were unwilling to pay given the lack of improvement on covenants in an increasingly overheated market.

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“[Investors] vent after something particularly egregious happens and then we hear some nice words about how everyone is going to play ball in future,” says one high-yield fund manager who declined to be named and whose firm is leaving. “But nothing ever changes.”

While AFME has no regulatory oversight, this month it published industry-wide guidelines designed to “maintain and improve business practices” in the junk bond market.

AFME’s chief executive Simon Lewis noted the new membership cost provides access to both the high-yield and securitisation divisions of the trade body.

“The investor membership category has been on a complimentary basis since AFME was formed in 2009, so we decided it was fair to introduce a modest annual membership fee for the services provided,” he said. “AFME very much values the participation of its investor members and we of course want to engage with as many of those members going forward as possible.”

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Over the past two years, protections in bond deals used by private equity companies to fund their takeovers have weakened dramatically, according to data from research firm Debt Explained’s “Aggressive Covenant Term Scoring” system.

“The deterioration of covenants is really being driven by private equity sponsors and their law firms,” says Thomas Ross, a bond portfolio manager at Janus Henderson. “Often the banks themselves are not actually aware of some of the nastier terms in the deals they are selling.”

Flush with cash after record fund raisings, private equity firms have sought increasingly aggressive debt terms to maximise their potential future profit from corporate buyouts at the expense of bondholders.

While investors have long complained about worsening covenants, the battleground has mainly shifted to tussles over “carve-outs” buried in the sometimes 1,000-page legal documentation accompanying bond sales. These exceptions to a rule are supposed to be narrow, but lawyers can make them incredibly broad with a couple of subtle tweaks.

One such carve-out is dubbed the “J Crew trapdoor”, named because private equity firm TPG took advantage of a loophole in the US retailer’s debt terms to strip out its intellectual property assets and move them into a new shell company at the end of 2016.

“The problem is that high-yield is very precedent based, so once you see language in the documents of one deal, it’s very hard to stop it spreading across the market,” Mr Ross added.

It is a view echoed by Sabrina Fox, co-head of European research at the credit research firm Covenant Review. The precedent-driven nature of the European high-yield market has led to “a race to the bottom” in the legal drafting of documentation, she says, adding that she can “guess what the covenant weaknesses will be just by reading which law firm advised the issuer on a particular deal.”

The bankers who sell these deals usually have a simple message for the asset managers and investment firms: if you don’t like it, don’t buy it. But junk bond specialists insist that an influx of “high-yield tourists” — non-traditional buyers drawn to the asset class for its higher yields — has made it harder for them to oppose looser covenants.

“When an insurance firm’s investment grade fund will buy a deal without even looking at the documentation, it doesn’t matter if we get angry and shout about it,” says a second fund manager.

Reports from firms like Covenant Review have given investors some ammunition with which to fight back against the most aggressive terms. European investors successfully lobbied several companies to remove the “J Crew trapdoor” from debt sales last year. And in January, debt collector Lowell-GFKL had to remove another controversial, yet subtle, covenant tweak from a new bond. This carve-out deleted just two words from a customary protection, but would have allowed the company to keep paying dividends for a full month after missing an interest payment on its bonds.

But while investors can count some recent victories in the tussle over deal terms, Ms Fox at Covenant Review says that the offending covenants “really shouldn’t have been included in those deals in the first place”.

Against this backdrop, it remains to be seen whether AFME can win back the support of the high-yield investor base. Of the 63 investor members across the two divisions, 37 have said outright that they are leaving, according to the people familiar with the matter. Of the remaining 26, only eight have so far agreed to pay.

One of the high-yield fund managers whose firm is leaving compared AFME to the United Nations.

“It’s a venue where people can voice their opinions, but what really matters is who sits on the security council,” he said. “And that’s not the investors; it’s the banks and law firms.”

Source : https://www.ft.com/content/410133e8-1093-11e8-940e-08320fc2a277

Tensions Over Junk Bond Covenants Start To Boil Over


Tensions Over Junk Bond Covenants Start To Boil Over