Short memories plague bond market

October 9, 2009

There’s something more than a little unnerving about the revival of the high yield debt market. Whipped on by low interest rates and  injections of liquidity by central banks, credit investors are increasingly piling into junk bonds.

But while bondholders have been rewarded handsomely, they appear to be turning a blind eye to weaker debt structures. This suggests they haven’t learned from the mistakes of the past.

So far nearly 10 billion euros of high yield debt has been issued this year. Many issuers, like carmaker Fiat or UK broadcaster ITV, are so-called fallen angels: companies that were once considered investment grade but have since been relegated to junk status.

Investors typically demand that high yield issuers pay a higher interest rate and abide by stricter covenants that limit the amount of debt they can take on.

However, this is not happening. Investors now appear to be willing to lend on the same legal terms as if the companies still had investment grade ratings. Some recent bonds issued by fallen angels do not contain clauses to protect bondholders against the risk the company takes on secured bank debt, leaving them with less in the event of a bankruptcy.

“There are very few protections in the covenants for companies like Fiat, Pernod Ricard or ITV,” says Alexander Dill, a senior covenant officer at Moody’s Investors Service in New York. “The protections against further leveraging just aren’t there.”

This is reminiscent of the boom, when aggressive private equity groups took advantage of cheap credit to extract better terms from their lenders.

The crisis may have put an end to covenant-lite bank loans. But the bond market has retained its bad habits. What’s more, this laxity isn’t just reserved for fallen angels that may regain their investment-grade status. Other high yield issuers are also still enjoying some of the loose terms they got during the boom.

The rebirth of the high yield market is vital for financing European companies. As banks rein in lending, corporations are increasingly dependent on the bond markets. But investors should be wary. The market is still nascent and a series of bad deals could spark a disorderly rush for the exit.

Bond investors already have less control than bank lenders. As they step in to fill the gap left by banks, investors must be careful that they don’t get taken for a ride.

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