Leveraged Loan and High Yield Bond ETF's a Reflection of Credit Activity
Whether banks are lending or hoarding cash is a major concern in today's market. Obviously U.S. banks are cautious given America's past financial crises, which saw it's fifth anniversary this weekend. Now debt markets are tilted in favor of borrowers. To a degree, in fact, that makes one question extent and prudence of borrower accommodation in view of covenant-lite debt.
Two exchange traded funds (ETF's) demonstrate degree of borrower as opposed to lender accommodation. These ETF's are high yield bond and leveraged loan products. Namely, we have SPDR Barclays High Yield Bond ETF (JNK), with an average trade volume of 6M shares. Second, is PowerShares Senior Loan Portfolio (BKLN) trading an average of 3M shares. Both are reflections of lending to business, either through bond issuance or loan syndication. With these kinds of bonds and loans, banks are "also" participants, along with various institutional lenders (pension funds) and hedge funds.
These ETF funds reflect demand for yield associated with leveraged loans and high yield bonds. They also reflect a trend in debt markets of relaxing covenants that otherwise protect lenders. A common argument is that covenant-lite debt prevents bankruptcy. Also arguable is that covenant-lite debt forestalls a bankruptcy or restructuring only for progressing financial deterioration.
High Yield Bond ETF's, Declining Cash Flow and Declining Covenant Quality
JNK, a high yield bond ETF, has witnessed, as with all other fixed income modalities, major retail cash outflows given prospects of Fed tapering. For year to August, an August 22 Forbes report shows high yield bond fund outflow of -$7.3B versus last year's same period in flow of +$21B. Despite outflows, high yield bond demand remains solid with JNK resisting net cash outflow to sustain pricing at its 200 day average. In fact, JNK has dipped twice of recent below its 200 day average and, as of August 20, started an arduous journey returning to and exceeding this level now.
Accounting for JNK price resilience is demand for yield, or income, against a now expected mild Fed tapering and consequent anticipation of leveling interest rates. JNK price resilience goes back to July when reports show bonds rated CCC and lower gained some 7.1% year to date while investment grade bonds declined 5%.
Along with high yield bond price resilience is an equal decline in creditor protection seen in indenture covenants. Moody's reports an index of covenant quality. Ratings range from 1 to 5 with 1 being strongest of debt covenant provisions while 5 is weakest. Debt covenant provisions were very strong following the financial crises and Great Recession, for good reason. However, in July 2012, strength of covenant provisions started a decline. By November 2012, covenant quality reached a new low with high yield covenant-lite packages reaching 30% of issuances versus a 17% historical average according to Reuters. November 2012 showed a covenant quality score of 4.15.
For August, 2013, Moody's showed a covenant quality rating of 4.01 versus July's 3.79. Starting latter 2012 to present, we see a sustained and expanding borrower oriented market for junk bonds.
Leveraged Loans and their Sustained ETF Pricing, but Declining Covenant Quality
Leveraged loans show same dynamic, but without cash outflow for their ETF's. Senior loan funds--sometimes called bank loans or leveraged loans--showed 65 consecutive weeks of cash inflow as of September. Reason for leveraged loan ETF sustained positive cash flow is nature of a loan over a bond. Loans conventionally have credit protection by being senior to even "senior notes" in terms of creditor protection. They also enjoy interest rate protection by being variable. Usually, a bond or note will have fixed interest where loans will be LIBOR plus negotiated basis points.
Also accounting for strength in loan ETF's is underlying loan market strength. Institutional leveraged loan volume for first half 2013 increased 122% at $268B versus same period 2012 at $121B. Institutional firms appear to be lending with confidence, while bank leveraged loan lending is up 3%.
Though loans enjoy superior credit and rate protection over bonds, they remain subject to strengths and weaknesses of their borrower. Like decline in high yield bond covenants, loan covenants have also been in very significant relaxation.
Leveraged loan covenant relaxation is breaking records and exceeding frothy pre-crises levels, substantially. As of August 8, 2013, Forbes reports $162B in covenant-lite loans. Number is 22% above 2012 levels and contrasts with just under $100B in 2007. Leverage ratios have also expanded beyond 2007 levels. Despite this, total debt does appear below 2007.
With leveraged loans and high yield bonds both granting declining creditor protection, environment is certainly borrower friendly. With 56% of loan issuances being refinancing, companies are taking advantage and relieving themselves of creditor oversight, limitations and burdensome performance (or maintenance) covenants.
Performance covenants in loan agreements have traditionally been used to help assure loan repayment. Limiting covenants in bond indentures protect payments to bond holders. Complying with covenants can, however, constrain business decision making and blunt a company's ability to pursue investment and opportunity.
What Covenants get Removed to Form Covenant-Lite Loans and Bonds
High yield covenant-lite indentures generally don't have a limitation on indebtedness provision and/or a limitation on restricted payments provision. Leveraged loan covenant-lite agreements are missing a maintenance covenant.
Covenants are generally divided into maintenance and incurrence covenants. A maintenance covenant requires a company to maintain a certain level of performance and are associated with leveraged loans. For instance, a leverage covenant might require a company to maintain its leverage at no greater than 4x debt/EBITDA. Other common maintenance covenants are cash ratio and interest ratio. Cash ratio monitors cash flow to debt service and interest ratio monitors EBITDA to interest expense.
Incurrence covenants, typically associated with bond indentures, require companies not to incur other obligations that might impair payment to, or credit priority of, bond holders. Common are limitations on indebtedness and restricted payments.
Limitation on indebtedness prevents a company from incurring additional debt that would make its leverage ratio exceed, for instance, 4x debt/EBITDA. Limitation on restricted payments limits a company's cash outflow. This is done by restricting dividend payments, acquisitions and certain investments. Generally, restriction on payments limit a company's external investment.
Covenant-lite Debt Preventing Bankruptcy, or Making Bankruptcy Impractical
When there is an absence of a maintenance covenant in a company's loan, and an absence of limitation on debt and no restricted payments on its bond indenture, no limitation on leverage or cash outflow exists, despite other peoples' money as leverage. Accordingly, the company isn't under a burden to keep earnings in line with debt. The company is free to make decisions, including accumulating more debt, as if it was financing itself on its own cash flow.
While most companies will obviously choose not to financially explode, real issue arises from a capital structure perspective. Notion is that covenant-lite debt prevents bankruptcy by giving a company latitude to develop additional funds.
Or, another way of looking at it, covenant-lite debt allows a company to kick the can down the road accumulating more debt, or issuing more equity, or both. All the while the company has expanding leverage multiples and equity dilution. What a potential nightmare.
Without having restrictive covenants described above, companies with covenant-lite debt don't have objective measures determining when enough is enough. A company could potentially become a debt machine, until an actual default occurs. Meaning the company is actually out of cash, after potentially having entered into lease buybacks, deteriorating available collateral.
Because bond holders generally are junior in creditor priority to loan holders, bonds will probably get nervous first. But, nervousness might not show until there are few assets for distribution among previously expanding creditors.
If companies leverage up due to the latitude given them with covenant-lite debt, deterioration of macro liquidity could impair ability to refinance their leverage, hastening crises, rather than preventing it. After all, most covenant-lite lending is due to refinancing currently, and not leveraged buyouts.
Covenant-lite debt does grant considerable latitude to companies. So long as companies don't use it as an invitation to over leverage, and liquidity conditions allow refinancing of debt. every thing looks good.
Circumstance to really watch is frequency of a triumvirate of all three covenants missing at once.
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