Avoiding the Losers At Hotchkis & Wiley, we believe that averting mistakes is the single most important quality in successful high yield investing. We are not immune from making mistakes, but avoiding high defaults and low recovery rates is a key tenet of our strategy. This “avoid the losers” mentality is achieved by focusing on several factors. First, we have a preference for securities that are senior in the capital structure, i.e. we prefer senior or senior secured to subordinated bonds. Second, we emphasize asset coverage, where the value of the assets provides morethan- sufficient support. Covenant packages represent a third layer of defense that we believe is often overlooked.
A tight covenant package guards against management behaviors that might be favored by equity shareholders or other stakeholders, but could put bondholders at risk. The level of conservatism exhibited by covenant packages varies with the credit cycle. When spreads rise and investors become more risk-averse, covenant packages tend to become more restrictive. Conversely, when spreads narrow and investors become less risk-averse, covenant packages tend to become lax. Today’s spread environment resembles the latter, so we thought analyzing covenant trends would be a productive exercise. This newsletter will attempt to identify broad trends in covenant packages by dividing covenants into three categories: 1) redemption flexibility; 2) negative covenants; and 3) change of control provisions.
Before we begin, it is important to note that we view covenant packages as an important risk control but one that is tertiary to seniority and asset coverage. An air-tight covenant package cannot transform a bad credit investment into a good credit investment. Conversely, a senior secured credit with tremendous asset coverage but a weak covenant package could still be a good investment.
Special note: Because covenants are idiosyncratic, analyzing broad trends is complicated. In fact, obtaining and aggregating reliable data is a challenge. To this end, we would like to extend a special thanks to Xtract Research (www.xtractresearch.com), which has done extensive, first-rate work on credit covenants. Much of the data provided hereafter was derived from Xtract’s pioneering research.
I. Redemption Flexibility
The terms and timing with which a bond can be redeemed is one of the most important covenants for investors to consider. All else equal, the more flexibility issuers have to redeem its bonds, the less appealing the terms for investors.
Historically, most high yield issues contained a covenant denoting that the bond could not be redeemed by the issuer until a specified period had elapsed. The most common period was the bond’s half-life; i.e. 4 years for an 8 year bond. In credit vernacular, this feature is most often referred to as call protection—a characteristic absent in most leveraged loans. From the investor’s perspective, reinvestment risk increases when the issuer can call the bonds. The investor receives cash for the bonds, which is likely to be invested in a less favorable interest rate environment. Setting aside interest rate considerations, the longer the non-call period is the better for the investor. Chart 1 depicts the number of new high yield bond issues that contain an explicit non-call period covenant1. The current market standard is an 8 year bond callable after 3 years. The number of bonds issued that contain a non-call period of less than three years, however, has increased considerably in recent years.