Q1 2024: Mitigating Tail Risks Through Credit Quality

Summary

• Changing macro narratives during the first quarter reflect an increasingly volatile world. The best hedge against this volatility and tail risks remains a focus on credit quality, with particular attention paid to free cash flow generation.


• Covenants in high-yield notes remained loose in the first quarter. Our data on debt and leakage capacities and aggressive terms show little indication that investor concerns about volatility are driving a push for tighter covenants.

As historians refer to “long centuries” - a more suitable period than measured by the calendar - investors can talk about the “long first quarter”: From mid-December 2023 to mid-April 2024, many believed that inflation was increasingly under control, economic growth was robust, and the Federal Reserve could begin easing monetary policy.

There was, in other words, a narrative, although one largely (though not entirely) promulgated by the central bank itself.

Stories are, of course, a natural way to convey information - whether in the press or an investment committee memo - but they are only a shortcut: Reality is often more complex and messier.

Since starting these memos one year ago, we have repeatedly emphasized the need to appreciate new paradigms to better understand the world as it is and where it is going. In particular, as we wrote following the first quarter of 2023, “a multitude of factors indicate that we may no longer be living in a low-inflation world.” These include the costs of the climate transition, labor shortages as populations age, geopolitical and trade frictions, and higher government spending. We also at the time noted the role of inflation-inducing defense spending at the start of a year that we now see had the highest-ever level of military expenditures.

These points speak to the increasing complexity of a seemingly leaderless world, one where the lines between politics and finance are blurrier than they have been in living memory and where the relatively simple days of the Washington Consensus are behind us. Volatility is, in other words, an inherent feature of the world today.

This, however, makes the market’s data dependency problematic: Every monthly data point - nonfarm payrolls, consumer price index, personal consumption expenditures inflation, and so on - is scrutinized to discern the path of rates, but these measures are often revised, contradictory and lagging. This is how we entered a period from mid-December when the market - spurred by the Fed’s change in messaging - expected a half dozen rate cuts in 2024. By mid-to-late April, however, following the Fed’s acknowledgment that it is too soon to ease policy, the odds of rate cuts fell and some - for the first time this year - have even started to expect further tightening.

The main message during most of the quarter was one of optimism: Although rate cuts kept getting pushed back, this was because of a strong economy - with good odds of a “soft landing” - and the Fed frequently reiterated that cuts were a matter of “when” rather than “if.” Economic resilience also included the erosion of credit spreads, but investors were happy with high headline yields. With issuers accepting higher base rates and willing to pay relatively little in the way of spread, the high-yield primary market boomed. This window was particularly important for issuers facing upcoming maturities and who saw, over 2022 and 2023, a market that could close without warning.
​

​


Though spreads trended tighter over the quarter, persistent inflation surprises - where it became apparent that the last mile journey to hit the Fed’s 2% target will be difficult - generated upward pressure on Treasury yields. This was particularly the case in March, when narratives started to adjust to sticky price increases. At this point, investors began to price in three rate cuts over the course of the year, down from six or seven at the start of 2024.

Subsequently, in April, Treasury yields moved higher, as release after release confirmed that inflation still has a ways to go to hit 2%, and the odds of rate cuts fell even further. The upshot is that - as was the case throughout much of last year - rates are expected to stay higher for longer.

Narratives, in other words, change, and, in a world that is getting more volatile, they will only get more muddled.

The above thoughts prompt three points for reflection as we get further into an interesting quarter and year - particularly with the U.S. election - that could spring any manner of tail risks.

First, as alluded to above, issuers should be prepared to take advantage of market windows while they can. Rates will likely go down at some point, but if the economy remains strong and inflation stays persistent, they can be expected to stay at or near current levels for the foreseeable future (and if the economy weakens, rates will drop but spreads will widen). With spreads hitting historically low levels, issuers with a need to term out maturities should be prepared to come to market when they have the opportunity to do so.

A good example is Altice USA: In January, the company initially announced a $1.25 billion five-year deal to partially refinance a loan due in 2025. It then upsized the offering to $2.05 billion, and the new notes priced to yield 11.75%, much wider than its existing curve. The revised transaction enabled the company to clear its maturities to 2027, and the pricing implies that it paid a premium to do so, potentially with a view that it should approach investors while it had the opportunity.

Second, investors will need discipline to successfully navigate a world of changing narratives and volatility. This was the theme of our last piece, and events during the quarter have borne this advice out. We wrote at the time that “the macro outlook remains shrouded in fog: Messages change as new data points emerge that create new narratives. Under these conditions, investors must find ‘anchor points of certainty’ on which to base decision-making so that they can hedge against the risk of mistaken beliefs and preserve a margin of safety.”

With data points that keep surprising and uncertainties in the tails of probability distributions, our view remains unchanged: “[I]nvestors will need to pay careful attention to credit quality to hedge against the risk of mistaken beliefs and ensure sufficient downside protection.” “This means investing in businesses that generate sufficient levels of free cash flow and, for buyouts, ensuring that sponsors have clear plans to achieve this metric.”

Third, first-quarter new issuance activity raises interesting questions about the changing nature of the leveraged corporate debt markets. The process of disintermediating banks accelerated in the 1970s, with the growth of the investment-grade bond market. This was followed, in the 1980s, by the high-yield market. More recently, the tension between syndicated loans and bonds has been heightened by the availability of private credit.

What is particularly notable is that much in high yield is standardized, with many new U.S. issues coming to market in drive-by format for quick execution. Further, as seen in the following two charts, most activity in the first quarter - as measured by deal values - was for refinancings and for BB and B rated paper.

 

Of course, this relative conservatism could be related to a market that needs to find its feet again after a challenging couple of years. But we know that across the United States and Europe, the average rating for bonds is higher than for loans.

The chart below shows how, despite tight spreads, investors are still focused on quality, with a bifurcation between BB and B spreads - which have materially compressed - and CCC spreads - which have not.

With syndicated loans and private credit fighting it out for the riskiest deals, these points suggest that corporate bond markets are becoming increasingly commoditized places for funding just the right level of risk - credits and paper that provide a decent return but which are not overly fragile. This includes the investment-grade market, where BBB rated bonds make up roughly half of the U.S. index, a much higher level than was historically the case. They also, in turn, beg further questions about the role of technology in changing the nature and structures of these debt markets, a potential additional source of risk and volatility in years to come.

High-yield bond covenants remained loose in the first quarter of 2024. Indeed, the data presented below suggest that, at least based on certain measures, investor protections may be becoming weaker compared with those in 2023. In any event, there is little indication that investor concerns about volatility are driving a push for tighter covenants.

As in the fourth quarter of 2023, it appears that there was limited successful pushback on covenant terms during the first quarter. Reorg is aware of only one first-quarter deal involving document changes in noteholders’ favor. For Crash Champions’ secured notes announced on Jan. 23, the pricing term sheet disclosed a handful of changes, presumably due to investor pushback, including the addition of a J.Crew blocker and reductions to the size of certain restricted payments baskets. However, various other aggressive terms were left untouched, and the deal remained an aggressive one on the whole.

In at least three first-quarter deals, debt and/or liens baskets were loosened relative to initial terms. While in each case, these changes appeared to have been made to reflect changes to the allocation or sizing of the overall financing package, such changes nevertheless allow the issuer to take on more priming or dilutive debt and are therefore unfavorable to noteholders. We noted these changes in connection with our review of Husky IMS’ secured notes offering in January.

One of the most aggressive deals of the quarter was Howden’s offering of new secured and unsecured notes, announced Jan. 29. Aggressive features of the Howden notes include an unusual variation of a “high-water mark” calculation mechanic for grower baskets, carry-forward and carry-back mechanics under all annual amount baskets, and leverage-based change-of-control portability.

Our covenant analysis of the Howden notes can be viewed HERE.

Medline’s secured notes offering, announced on March 19, was also aggressive. In addition to providing enormous debt and leakage capacities, the Medline notes included a “weaponized” asset sale covenant allowing all asset sale proceeds to be used for restricted payments without depleting capacity, leverage-based change-of-control portability and a “Voting Cap” provision limiting an individual noteholder’s ability to dominate voting determinations.

Our covenant analysis of the Medline notes can be viewed HERE.

Some of the terms seen in the Howden and Medline offerings are rarely seen in U.S. high-yield notes, in particular the high-water mark mechanic in the Howden notes. We will keep an eye on this area going forward to determine whether such terms are seen more frequently in the U.S. market.

For new bond issuances reviewed by Americas Covenants in the first quarter of 2024 and the prior four quarters, the table below summarizes flexibility (1) to incur additional first lien or secured debt; (2) to transfer value to unrestricted subsidiaries; and (3) to transfer value to equity through dividends or other distributions.


The percentage of new deals reviewed each quarter that included various aggressive terms that we track in our primary high-yield covenants coverage is shown in the chart below:


Some deals have been excluded from the data presented above, including notes lacking full covenant packages and notes with atypical negative covenant packages.