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Covenant conundrums

by Mark Parsley

Updated: March 19, 2019

Last year was a good year to be a borrower. Not only were credit conditions easy, loan documentation became ever friendlier. According to Covenant Review, a specialist in covenant analytics, key covenants were relaxed, including those covering EBITDA adjustment terms, free-and-clear incremental tranches and MFN sunsets (which generally guarantee existing lenders cannot lose out if new lenders get better terms on incremental tranches).

This year should be different. Rates are rising, with markets pricing in three Fed hikes this year and bank lending to US corporates has stalled since the election, so investors should start to push back against those covenants. And at first glance, that is happening.

In September 2016 a court case in New York ruled against a high-yield bond issuer, Cash America, which had effectively claimed that even if it was in breach of a bond covenant (via an asset spin-off) it did not need to seek bondholder agreement or call the bonds at a premium. Instead bondholders either had to redeem at par or continue to hold bonds with weakened credit quality. The court held that a make-whole premium (to par) is payable where a company defaulted through voluntary action. (A voluntary default, through covenant breach, is a way to redeem only at par rather than pay the premium).

Then, in another case involving issuer Energy Futures, decided in November 2016, the U.S. Third Circuit held that a company must pay a make-whole if notes are repaid in a bankruptcy. This extension to the idea caused a problem: most issuers understand the notion that they should pay a premium for being able to skip a covenant and redeem notes. But they are not so keen on the idea that they should pay a premium on default in bankruptcy. So after the ruling, more than a dozen new issues began to be marketed with language that opted-out of the court’s decision.

This was seen by some investors as the thin end of a wedge that might allow issuers to opt out of other court decisions and structure bonds with ever more limited covenant protection. Investors rebelled and they won: bond offers by General Motors’ financial subsidiary, chipmaker Broadcom and the Brazilian pulp manufacturer Fibria Celulose and others were forced to drop the opt-outs from their deals.

So is this the first sign of lenders finally reasserting control? Not yet. Take the US leveraged loan market. The amount of loans without covenants in the US is on track to surpass the US$128bn quarterly record, set in the fourth quarter of 2016. US Foods recently repriced a US$2.2bn term loan without covenants and telecommunications firm Level 3 increased a covenant-lite loan to US$4.6bn from US$2.6bn.

And issuers have also been able to pass risks that they would normally assume onto investors. In mid-February Viacom issued a $1.3 billon bond that can be redeemed should the tax deductions it is permitted to take on its interest payments be eliminated or even challenged. Interest rate deductibility is one of the possible mechanisms the Trump government has flagged as a way to finance tax cuts.

The clause is more evidence that borrowers still have the upper hand in covenants because it passes tax risk from issuers to bondholders despite investor pushback. The original clause allowed for redemption at par. After negotiations, investors successfully gained a percentage point for the risk they were being asked to shoulder.

However, the supply demand imbalance in the markets is most pronounced in the higher-yielding sectors. How long investors will be a pushover remains to be seen.