The Credit Markets Continue to Morph – Junk Bond Investors Want More Protection

As one might expect, if the terms in the credit markets change business are forced to adjust to accommodate the “new perception” of risk. This doesn’t mean that business stops, but the riskier deals may not make it anymore and the more questionable deals may require changes in the convenants. From Market Watch:

A growing wariness in the junk bond market is prompting suddenly savvy investors to demand that tough new protections against certain risks be built into the covenants of high-yield bond offerings.

In another sign of the times, for the first time in years, issuers are being forced to cancel the most hazardous junk bond deals.

The changes come at a time when the deteriorating subprime mortgage market is forcefully reminding investors about the dangers of risk. This marks a real switch from earlier in the year when many investors seemed blithe about junk bond risk and were willing to take on the shakiest of credits for the prospect of higher returns.

New risk-adverse structural changes within bond underwritings include "poison pill" covenants in high-quality corporate bonds that carry "change of control" rules in the event of a takeover, according to John Atkins, a fixed-income analyst at IDEAGlobal.com.

Under "poison pill" covenants, bond investors have the right to be bought out with extra interest by bond issuers if there is an LBO.

"The language in the deal lets investors that bought at par, get bought out at par plus," Atkins said. "We are seeing that in more and more offerings."

Leveraged buyouts generally wreak havoc on a company's bond rating, as private equity firms typically issue large amounts of new debt to finance these deals, often borrowing at least two-thirds of the purchase price. The increase in debt frequently pushes the ratings of the acquired companies' debt lower, and often they end with speculative, junk status.

In the current risk-averse scenario, many investors also are rejecting the so-called "covenant-lites" or pay-in-kind "toggle bonds" that allow a financially-strapped issuer to avoid making interest payments by instead issuing more junk bonds to the holders. These covenants often allow issuers to get past restrictions that peg the amount of money a company can borrow to its free cash flow.

But "toggle bonds" were not in favor this week when ServiceMaster Co, which operates pest control and gardening companies, had trouble finding buyers for a $1.15 billon "covenant lite" junk bond offering.

But, despite the new trend of cancellations and demands for investor protections, the junk-bond deal flow remains heavy, as the flow of leveraged buyout deals continues undiminished.

"There are quite a few deals in the pipeline," said John Atkins, a fixed income analyst at IDEAGlobal. com. "It will be a real test of risk tolerance, given the record pace of deals getting done in junk bonds. But what we are seeing is not just a number of deals being postponed, but also a significant number being restructured."

The vast pools of international liquidity that fuelled the leveraged buyout craze may be shrinking a bit, but have certainly not disappeared and should continue to support the junk bond market for the rest of the year, (my emphasis) according to A.G. Edwards' Hornbarger.

"It is a little bit more of a difficult environment to operate in, but it is by no means impossible," Hornbarger said. "There is still a lot of liquidity out there and we are far from the point where the market can't function."