How are high-yield investors gaining an advantage over market participants?

Amid weak global economic conditions and higher demand for safe haven assets, high-yield (HY) debt issuers have become increasingly cautious when it comes to market participation. Of late, issuers in the HY category have either tightened control on deals or switched to other means of financing after struggling to gain investor confidence in a muted primary market.

HY debt papers come with high interest rates, as these issuers pose greater risk of default given that the entities categorised as HY are either highly levered or financially distressed. This category of issuers could also include smaller or emerging ones, which may need to raise funds via HY bonds to offset their unproven operating histories or serve their business trajectories that might be speculative or risky. As a result, the yield on such instruments is typically higher to bring in investors and compensate them for the degree of risk they take on. Investors with greater risk tolerance find these debt papers attractive, particularly in low interest rate environments. From a credit rating perspective, Moody’s rates these bonds as Ba1 or below, and S&P and Fitch rate them as BB+ or lower. In the financial markets, these bonds are also known as junk bonds or speculative-grade bonds.

Given the ongoing uncertainty and rate hikes, issuers or borrowers are now cautious about engaging in the HY market. US HY deals, for instance, did not gain traction during the first week of May 2022, and the ones that supposedly had the timelines in place eventually got withdrawn. Moreover, HY investors have been shying away from the market lately, observing that preliminary and actual corporate earnings are showing declines, particularly adjusted EBITDA and sales. Rating agencies have also remained guarded, assessing that issuers may be highly levered.

In May 2022, Bioventus, a US-based pharma player, struggled to place its proposed senior notes offering in the primary market; the planned issuance was intended to finance its acquisition of CartiHeal, a pharmaceutical entity headquartered in Israel – Bioventus’s third acquisition since 2021. The USD415m five-year non-call senior notes issuance was set to hit the market at a high cost, with an initial price talk range of 9.75-10%, remaining way above the average effective yield of 6.96% on the ICE (NYSE:ICE) BofA US HY index. However, considering unfavourable investor feedback and current market conditions, the company decided to explore alternative financing options for the acquisition.

HY bond losses have also accelerated after mixed signals from the Federal Open Market Committee (FOMC), causing uncertainty over the number of rate hikes in the coming months and their repercussions on economic growth. Primary markets witnessed some issuers charging towards taking advantage of this risk-on mood prior to the commencement of the Jackson Hole Symposium – at which the Federal Reserve’s (the Fed’s) chairman Jerome Powell eventually delivered hawkish comments.

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Amid this current market scenario, HY investors have been able to put pressure on issuers to make certain amendments in debt covenants as they became cognisant of issuers’ growing need to raise new debt from the market. After years of erosion seen in bond documentation, the current poor market environment has given investors the upper hand in negotiating debt covenants, although some still overlook the aggressive language in the indentures as long as the transaction comes at an attractive price or yield. In addition, over a decade of extremely cheap liquidity had meant that investors had little option but to accept the never ending assertive terms in the offering documents. However, as central banks across the globe began to reverse quantitative easing to fight inflation, investors have finally realised the opportunity to demand greater covenant security and rein in some of the exceptional amount of freedom given to borrowers in recent years.

To define covenants, these are a set of rules and terms mutually agreed by all parties involved in a deal; on the basis of these, limits and constraints are set in raising finance via different asset classes. Covenant documentation signifies a binding relationship between an investor and issuer. The agreements can permit or put a constraint on an activity during a particular transaction. Certain binding clauses, when breached, may trigger a compensatory or legal action. Covenants could be both negative and positive/affirmative. Negative covenants often refrain issuers from actions that could lead to a deterioration in their credit reputation or ability to repay existing debt. Common examples could be dividend declaration, restrictions on management fee from related parties etc. On the other hand, positive or affirmative covenants allow the issuer to perform certain actions. These commonly include maintaining adequate levels of leverage, ensuring compliance with applicable regulations and maintenance of credit rating and proper accounting books. A breach of positive covenants may lead to an outright default.

The market’s moderate risk appetite has enabled investors to curb issuers’ movements, forcing underwriters and entities to agree upon restrictions that lend strength to investors’ interest payment prospects. In a recent case, 888 Holdings, an issuer belonging to the casino and gambling industry, was made to amend some of the terms in its debt indenture. The debt comprised a EUR400m, 7.558% senior secured five-year bond non-callable for two years (5NC2) and a EUR300m senior secured 6NC1 floating rate note. The agreement initially contained an aggressive covenant package that permitted the entity to exclude material amounts of debt from its key ratios, which would have changed the direction of covenant calculations in its favour. One amendment involved the reduction of the leverage ratio from 4.0x initially to 3.5x, and the corresponding part of the acquisition financing was also similarly reduced. The company was also forced to cut out other unusual provisions that would have allowed it to increase debt levels beyond permitted thresholds. Eventually, the two tranches of 888 Holdings’ bond offering was priced at a discount of c.85, lower than initially estimated.

Instances such as this also serve to show that investors are generally inclined towards the price of a security and favour good companies with poor covenants rather than bad ones with good covenants. In the case of 888 Holdings, for instance, investors were willing to participate in the issuance given the company’s financial strength and, particularly, the yield of 11.5%.

HY debt markets have rarely seen deals with document rewrites when compared with the loan market, which is not a surprise, as loan markets have actively been creating such instances. That said, such covenant modifications could grow in number in debt markets, as issuers have been desperately seeking sources to raise funds amid the current hostile market conditions, ultimately giving HY investors the upper hand over companies. As of YTD 2022, US HY corporate debt issuance volumes amounted to USD86bn, 78% lower than the same period in 2021, amid rate hikes and central banks’ measures to reduce stimulus, which have turned the tables for market participants as borrowing costs have surged.