Fri 10/27/2023 10:10 AM
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Credit Research: Rob Sommers, JD, CFA
Americas Covenants: Mitch Oates, JD


  • The macroeconomic holiday from history is over, and volatility - economic and political - is back. It is now more important for investors to understand risks, particularly tail risks, than at any point in decades. This is especially true in primary, where upside is often limited.

  • Leveraged issuers face a wall of liabilities in 2025 and beyond. Investors will, therefore, demand higher yields to refinance low-coupon, pandemic-era debt and will scrutinize sponsor-backed deals, expecting higher equity checks and tighter covenants. In short, power may be shifting from borrowers to lenders.

  • Despite the changing conditions, deals reviewed by Americas Covenants showed no obvious improvement in covenant protection during the third quarter. While there was some investor pushback, it tended to be most meaningful where it was least necessary.

When Francis Fukuyama declared the “end of history,” he was describing the triumph of liberal democracy at the conclusion of the Cold War. The term could have applied equally to fixed-income markets, which since 1980 have benefited from accomodative monetary policy. Rates peaked at almost 20% in the early 1980s, then they hit zero during the global financial crisis of 2008 and remained low until the recent bout of pandemic-induced inflation.

A generation in the credit markets has seen rates travel in only one direction, creating the impression that this state, benefiting borrowers and asset owners, is “normal.” Back in January 2020, The Economist cited research indicating that “real interest rates have fallen from an average of around 10% in the 15th century to just 0.4% in 2018.” It continued, “If the historical trend continues, by the late 2020s, global short-term real rates will have reached permanently negative territory.”

Fukuyama’s thesis was quickly discredited by 9/11, Russia’s 2014 seizure of Crimea and other events, and it is only now that we are questioning our assumptions of how finance works.

A symptom of the macroeconomic holiday from history has been a failure to realize that the political and economic are joined at the hip: Lower rates were largely driven by the deflationary impacts of globalization. This meant that many were surprised by the absence of inflation when central banks cut rates in the aftermath of the global financial crisis, and so, by the end of the decade, proponents of modern monetary policy could point to rock-bottom levels of inflation as proof that that genie was now firmly in its bottle. It took a pandemic and geopolitical dislocations to uncork it.

Many central bankers insisted that higher levels of inflation were “transitory” until long after it was clear that they were not, and the debate has now shifted to whether the neutral interest rate has gone up and whether the Fed’s 2% interest target remains appropriate.

We are, in other words, in a new economic world, and the credit markets have spent 2023 trying to make sense of volatilities and uncertainties that few have experienced in their careers.

The year started with predictions that the federal funds rate would peak at 4.75% to 5% in March, 50 basis points lower than the current 5.25% to 5.5% range set in late July, a 22-year high.

Apart from the crisis that engulfed Silicon Valley Bank and other lenders, rates and spreads were engaged in a sort of choreographed two-step dance until the end of the summer, with increasing rates offsetting tightening credit spreads. This meant that, from March 1 to Aug. 31, U.S. single-B credits traded in a yield range of 8.3% to 9.1%. By contrast, during the same period, the five-year Treasury traded between 3.2% and 4.5%, and the single-B spread was between 3.9% and 5.5% (or 5.3% when excluding the period of SVB’s collapse), both wider ranges than the dispersion of overall yields.

This was driven by the belief that the U.S. economy was strong enough to avoid a recession and achieve a soft landing. This, in turn, created a supportive backdrop for new issuance activity, with corporates and sponsors taking advantage of the post-Labor Day period to come to market. Notable deals during the period included new issues for Syneos Health, Bausch + Lomb, Worldpay, NCR Atleos and Forward Air.

Weekly high-yield issuance volumes and issuance by sector during the quarter are shown below:


Any sense of a return to more benign economic conditions, though, evaporated during the third week of September, when the Fed stressed the need to maintain higher rates for longer. Single-B spreads, which hit their lowest point of the year at 384 bps on Sept. 20, the day of Fed Chair Jerome Powell’s speech, widened to about 450 bps within days, while U.S. Treasurys also jumped. Single-B yields, which were at 8.5% on Sept. 20, widened to 9.4% by early October, and new issuance quickly slowed down.

We saw this change of tone in late September - coincidentally in line with the change of seasons - as the market finally recognized what has been evident in the political domain for at least a decade: that volatility is back, and it is now more important to understand risks, particularly tail risks, than at any point in the last four decades.

Does this mean that all credit analysts should adopt a distressed lens? Not necessarily, as relative value is still important. But the range of possible outcomes is now wider than it has been, and investors need to understand downside risks in areas long taken for granted. For example, the rule of law continues to decline, raising questions about lending to companies based in, or with material assets in, creditor-unfriendly jurisdictions. Indeed, credit investing is based on contractual returns, and investors must be wary of countries that are willing, or have shown a willingness, to violate the sanctity of contracts. In other words, tail risks can mean a sudden widening of spreads.

This is particularly important in the primary market, where upside tends to be limited.

At the same time, geopolitical and trade frictions are expected to keep inflation above the levels seen before the Covid-19 pandemic. This will be compounded by increased climate and defense spending and labor shortages driven by aging populations in developed countries. Therefore, while rates may not stay at current highs, they are unlikely to fall to the levels seen in recent years.

New issue yields since the start of the third quarter plotted against credit ratings are shown in the graph below:

What does this mean for high-yield issuers and investors? The wall of liabilities maturing in 2025 and beyond, reflecting debt taken out at the height of the pandemic at low rates, is fast approaching and will need to be refinanced at much higher yields. The 2025 maturities will need to be tackled soon, and borrowers that had locked in long-term financing with attractive coupons will face much higher cash interest costs, which could impact liquidity.

Nonetheless, stronger-rated high-yield credits pursuing leverage-neutral transitions should be able to continue to access the market, so long as they are willing to pay. The environment may be more challenging with respect to sponsor-backed deals, for which the new level of debt costs and/or the need for stronger equity checks may be unsustainable. We may, therefore, see increasing numbers of sponsored deals funded by private credit, which could turn high yield into something that bears a bit more resemblance to the investment-grade market: a fairly vanilla tool for funding corporates.

Regardless of the nature of deal flow over the coming year, given the large numbers of companies facing a maturity wall starting in 2025, it may be that the time has finally come for a shift in power from borrowers to lenders.
Despite Volatility, High-Yield Covenant Protections Remain Weak

To the extent high-yield investors have begun to take account of increased volatility and the importance of tail risks, these concerns did not lead to any obvious improvement in covenant protection during the third quarter. Indeed, as summarized in the tables below, the flexibility to incur debt and move value away from creditors may actually have increased in the third quarter relative to the first two quarters.

Investors pushed back on several deals in the quarter, but to fairly limited effect. Apollo- and Brookfield-owned One Toronto Gaming’s 2030 secured notes offering (priced at 8% on July 20) featured a very issuer-friendly covenant package, including various aggressive terms and significant flexibility to incur additional debt or transfer value to unrestricted subsidiaries. The original terms were revised to remove a “Disregarded Amount” mechanic that effectively expanded debt and liens capacity by permitting a specified amount of debt to be excluded when incurring debt or liens under certain ratio-based baskets. While the provision is certainly aggressive and objectionable, its removal made little difference, as a number of other aggressive terms remained unchanged.

Similarly, investors pushed back on Syneos Health’s 2030 secured notes (priced at 9% on Sept. 19), issued in connection with the company’s acquisition by Elliott, Veritas and Patient Square. The revised terms reflected modest reductions to certain baskets and tightening of certain leverage tests. However, even post-pushback, the notes still provided significant flexibility to the issuer, especially for leakage to unrestricted subsidiaries.

Ironically, the offerings for which pushback was most meaningful tended to be those where it was least necessary.

Pushback to Apollo-owned Maxim Crane’s 2028 second lien notes (priced at 12% on Aug. 17) resulted in a complete prohibition on the incurrence of debt by nonguarantor restricted subsidiaries, in addition to reductions in size of various other baskets. However, the terms of these notes were already fairly tight, especially for a sponsored deal. Similarly, investors succeeded in making meaningful changes to the terms of Rain Carbon’s 2029 second lien notes (priced at 12.25% on Aug. 3), including an $8 million annual cap on all restricted payments and general-purpose investments until the company can meet a specified gross leverage test. Again, however, the original terms of the notes were already quite restrictive.

On the basis of the third quarter’s deals, it is not clear that the balance of power is shifting from issuers to noteholders with respect to covenant protections. However, as noted above, other indicators of market sentiment began to move only after Chair Powell’s Sept. 20 remarks. It may, therefore, be too early for any such trend to be evident in the documents, and it remains to be seen whether investors’ concerns about volatility will eventually drive a demand for tighter covenants.

For new issuances in the first three quarters of 2023 reviewed by Americas Covenants, 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 taps, notes lacking full covenant packages and notes with atypical negative covenant packages.
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