Investors Keep Buying US Junk Debt Despite Weak Protections

 

When US-based construction material supplier Wilsonart issued a junk bond to raise US$500 million (RM2.13 billion) for an acquisition this summer, a research firm warned potential investors about the bond's weak protections. The bond’s covenants could allow the company to move valuable assets to another entity and raise more money, potentially disadvantaging bond investors, according to Covenant Review, a research firm.

This warning comes amid growing concerns in credit markets as more companies engage in practices like "liability management exercises," where they borrow more against the same assets. These practices, often favoring some creditors over others, have been dubbed "creditor-on-creditor violence," prompting some creditors to unite to protect their interests.

Despite the warnings, investors eagerly purchased Wilsonart's offering, underscoring a paradox in US credit markets. While investors face the consequences of weak covenants, they continue buying new bonds with similar flaws without substantial resistance, credit market experts noted.

Why Investors Are Still Buying

The reasons, according to market sources, include a shortage of junk-rated bonds and the desire to lock in higher yields before the Federal Reserve begins cutting interest rates. Diverging interests between large and small investors also play a role.

"Investors have a tough choice: Do I sit in cash and not buy a bond or loan because of looser documentation, thereby risking hitting my return hurdles?" said Peter Toal, global head of fixed income syndicate at Barclays. Toal noted that most current borrowing aims to refinance old debt.

About 90% of high-yield bonds and loans sold in the market currently come with weak investor protections, despite concerns that stressed companies exploit these conditions to raise fresh funds, analysts say. The Morningstar LSTA Leveraged Loan Index shows that over 90% of loans are "covenant-lite," lacking maintenance covenants, a significant increase since the 2008 financial crisis.

Liability Management Exercises and Investor Risks

Common liability management exercises (LMEs) involve a company transferring valuable assets into a subsidiary, which then raises debt in a side deal from new and old investors. The cash is forwarded to the parent as an intercompany loan. The side deal gives new creditors a priority claim on the company's assets in case of bankruptcy, pushing existing investors further down the line and increasing their potential losses.

These high-yield bonds and loans are typically included in funds sold to retail and institutional investors, who may face losses or underperformance due to weaker covenant protections and covert LMEs.

Distressed Exchanges on the Rise

So far in 2024, 28 companies have completed distressed exchanges totaling US$35 billion, the second-highest total on record, according to JPMorgan. Moody’s has warned that 13.5% (or US$400 billion) of the over US$3 trillion in junk debt it rates is at high risk of default within the next 12 months, much of it structured with minimal or no protections against LMEs.

In response, investors are seeking ways to strengthen their claims on company assets. Many creditors are entering cooperation agreements or private legal pacts to enhance their negotiating power and prevent rivals from making side deals.

Steven Oh, global head of credit and fixed income at Pinebridge Investments, described the situation as a "classic prisoner's dilemma." He noted that investors must choose between enhancing their interests through side trades or aligning with others to prevent competitors from doing similar deals.

Some Pushback, But Change Is Slow

In some instances, investors have pushed back, refusing to buy new debt unless the borrower agrees to include clauses that protect existing creditors. For example, Moody’s noted in April that Thryv and two other borrowers faced resistance.

However, such pushback remains rare. In early September, Clayton, Dubilier & Rice (CD&R) marketed a US$400 million junk-rated bond through Fiesta Purchaser, prompting Covenant Review to alert investors about the bond’s problematic provisions. The review warned that the company’s ability to issue debt through a subsidiary could be taken to a "nonsensical extreme." A similar warning was issued for a new US$700 million bond by Focus Financial Partners. Both bonds were eventually upsized and priced after slight adjustments to the language.

Scott Josefsberg, head of high-yield research at Covenant Review, said the changes show that investor pushback can improve covenant protections, but much more is needed for a major overhaul. "A vast majority of bonds and loans have no guardrails against LMEs, and they are easily sold," he noted.