Bond Markets Get Riskier

By Carrick Mollenkamp and Mark Gongloff (WSJ)

Bond markets are growing riskier as investors seeking steady returns bid up prices and ignore some early warning signs similar to those that flashed during the credit bubble.

Last week, prices on high-yield, or junk, bonds hit their highest level since 2007, nearly double their lows of the credit crisis. Nine months into the year, companies have sold $172 billion in junk bonds, already an annual record, according to data provider Dealogic.

To some extent, the bull case for junk bonds is based on a declining rate of corporate defaults lately and a belief that, as long as the economy doesn’t relapse into recession, default rates will continue to decline. The financial crisis purged many weak borrowers from the system, and corporate balance sheets are generally stronger today than before the crisis. However, a double-dip recession could hurt another, albeit smaller, wave of borrowers.

The U.S. high-yield default rate fell to 5.1% in August from 13.2% a year ago, Moody’s Investors Service reported recently, adding it expected the rate to fall to less than 3% by the end of the year.

Interest rates paid by companies with strong credit ratings have tumbled this year, falling to 1.8 percentage points above the yields on comparable U.S. Treasury bonds, which themselves are among the lowest yields in decades. Companies with weak credit ratings are paying 6.2 percentage points above Treasurys, down from nearly 20 percentage points in 2008, according to Barclays Capital indexes.

Treasurys have already seen their weaknesses exposed after a recent sell-off. Since the start of September, 10-year Treasurys have lost 2.2% and 30-year government bonds are down 6.9%, compared with a 5.6% gain for the Dow Jones Industrial Average.

The demand for bonds has allowed some of the riskiest borrowers to sell bonds with fewer protections for investors. These provisions, or covenants, prevent companies from taking actions that would hurt bondholders and would protect investors if companies are sold.

The bond boom has so far been a positive for the economy, allowing the U.S. government and major corporations to borrow at cheap rates and giving weaker companies financial breathing room until business picks up.

But continued strong demand by investors can have unintended consequences. Cheap, plentiful debt fueled the housing and leveraged-buyout booms, both of which collapsed after buyers who borrowed too much couldn’t repay loans.

“Bondholders got burned” buying deals in 2005 through 2007 because indentures, or the contracts that govern the bonds, didn’t protect them, said Adam Cohen, founder of Covenant Review LLC, a New York credit research firm. “They said ‘never again,’ but now in a hot bond market, people are buying into those covenant loopholes all over again, and they’re going to get burned again.”

One reason why bond yields keep falling is lack of supply. Despite nearly two years of heavy borrowing by the federal government and nonfinancial corporations, the total amount of debt outstanding in the U.S. is still nearly $700 billion lower than it was at its peak in the first quarter of 2009, according to Federal Reserve data released on Friday.

Still, few analysts say the bond market is anywhere near as risky as it was several years ago.

“It’s more accurate to say that we’re still disgorging the last credit bubble than that we’re starting a new one,” says Harvard economics professor Kenneth Rogoff, who has studied financial crises with Carmen Reinhart of the University of Maryland and notes that new credit bubbles don’t typically form immediately in the aftermath of old ones.

While most analysts don’t think the bond market is in a bubble, they are seeing a repeat of some behavior from the last run-up. “In 2001-2003, clients were desperate for yield and were willing to invest in stuff you could tell was risky because it promised a higher return,” says George Feiger, CEO of Contango Capital Advisors. “You see the same pressure today.”

One of the worrisome developments is occurring in the junk-bond market, where companies are taking advantage of strong demand to sell bonds that have fewer protections for investors than similar bonds sold by the companies in years past.

Some have watered down covenants, which are supposed to protect investors if a company is sold and prevent companies from loading on too much other debt or paying out their cash, which would cause a drop in value of the bonds or make it less likely the bonds they hold would get paid off.

Fifty-seven percent of junk-bond issuers had less-stringent covenants than their previous junk deals, according to an analysis for The Wall Street Journal by Covenant Review which analyzed 58 junk bonds issued in 2010 by companies that previously had issued debt. Just one deal had stronger covenants for investors. Some 41% of the deals had the same covenants.

A decline in investor rights was a marker of a rising bubble in the years leading up to the market collapse of 2008. Just like then, investors are scrambling to invest in deals, some of which are completed in a day in what are called on Wall Street “drive-by” offerings.

“It reflects a weakening in covenant protections even below those existing at the peak of the market, in 2006 and 2007,” Alexander Dill said in a May report from Moody’s.

When Tenet Healthcare Corp. sold $600 million in junk bonds in August, investors had fewer protections than they had in previous Tenet bonds. The bond deal from the Dallas hospital operator and health-care company lacked an asset-sale covenant, which would have forced the company to use proceeds from the sale of a material asset to buy another asset, make capital expenditures or repay bond investors.

Those covenants also prevent companies from using cash from asset sales to pay salaries. The recent Tenet deal also lacks a restricted payment covenant, which blocks dividend payouts.

In an email statement, Tenet spokesman Rick Black says the recent debt sale was a private placement to sophisticated investors who understand credit markets and are “extremely well-informed about prevailing market terms” including covenants.

He added: “‘The market’ dictates the terms, condition and pricing of debt offerings.”

Two junk bonds issued by Chesapeake Energy Corp., an Oklahoma City company that is the second-largest U.S. natural-gas producer, illustrate how new bonds are being sold. In an August sale, Chesapeake sold $2 billion worth of junk bonds maturing in eight and 10 years. Chesapeake is using the bond sales to pay down existing debt and for general corporate use, the company said in an August news release.

According to Covenant Review, neither bond offers a “change-of-control” covenant. When that protection is included and a company is sold, bondholders can sell back their bonds at 101% of par value. In an Aug. 9 report to clients, Covenant Review said Chesapeake “is yet another issuer trying to take advantage of a hot market by quickly passing off a materially worse covenant package.” Mr. Cohen says that analysis reflects both the lack of a change of control provision and weak covenants that protect how assets can be pledged.

In an interview, Chesapeake Treasurer Jennifer Grigsby says investors didn’t want the covenant in the recent sale. “We were advised by our underwriters that we did not need to add a change of control” covenant in the deals “in order to achieve a successful sale of the bonds,” says Ms. Grigsby.

Ms. Grigsby acknowledges the sale took place quickly, but notes the offering was three-times oversubscribed and if investors had concerns after having more time to review the bond documents, they would have been selling the bonds. Instead, the bonds now are trading at 104 cents on the dollar. She also says the covenants limit Chesapeake’s ability to use its oil and gas properties to secure financing.

A spokesman for lead underwriter Credit Suisse Group said in a statement, “Chesapeake is viewed by investors as a high-quality issuer and has not included a Change of Control put provision in any of the bonds they have offered to U.S. high-yield investors for several years.”

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