Outlook 2013: Bond covenants lax amid heavy issuance; chemicals, oil and gas among weakest sectors

By Cristal Cody

Tupelo, Miss., Dec. 31 - The influx of new bonds in 2012 led to weaker covenants as investors searched for yield, sources said.

"We looked at 13 broad corporate sectors that had bond issuances," said Matthew Musicaro, an analyst at Moody's Investors Service. "Covenant quality weakened in six of those sectors, improved in three and was steady in four."

The sectors with the biggest declines in covenant quality included consumer products, paper packaging and technology, while the chemicals, oil and gas and health-care sectors remain the weakest, he said.

Sectors that improved over 2011 included metals and mining, leisure, lodging and entertainment and construction and homebuilding, he said.

Low point in November

"The lowest month on our covenant-quality scores was in November," Musicaro said. "These high-yield deals had a 4.15 covenant quality average [out of 5 points]; that was the worst month on record since we started scoring Jan. 1, 2011."

During November, some companies such as Huntsman International LLC and Sealed Air Corp. that previously used a traditional high-yield indenture switched to investment-grade-style covenant packages, which offer issuers more flexibility going forward, sources said.

Lien covenants protections have been particularly weak in 2012, Musicaro said.

"Investors were pushed further and further down the capital structure as interest rates go lower," he said.

The $500 million offering of eight-year senior notes (B1/BB/) that Inergy Midstream, LP and Inergy Midstream Finance Corp. sold at par to yield 6% on Nov. 29 had been cited for weak liens covenants in reports.

The liens covenant contained a subtle drafting flaw that would allow all loans and bonds to be secured, according to Covenant Review, an independent credit research firm.

Expectations for tighter covenants have fallen with the search for yield, bond sources said.

"The story of this year is that covenants are looser, and that's a function of the hot bond market," said Anthony Canale, an analyst at Covenant Review. "People are reaching for yield, and issuers are able to get away with looser covenants. They were not able to get away with it when the financial crisis hit and the bottom fell out and bondholders were expecting tight covenants in their bonds."

New trends

A number of trends emerged in 2012, particularly the reemergence of PIK toggle notes, Canale said.

"These were very common at the height of the LBO boom in 2007 and prior to that," he said.

Interactive Data Corp., Michael Foods Holding, Inc., EPE Holdings LLC and EP Energy BondCo Inc., Academy Sports + Outdoors and Taminco Acquisition Corp. all priced offerings of PIK toggle notes in December.

With the exception of the EP Energy deal, tighter restrictions for the PIK toggle notes emerged.

"When they started reappearing again, the PIK toggle language was tightened," Canale said. "In the old bonds, the company had the discretion to say it would pay all in PIK toggle notes, pay all cash interest or half and half. In the deals this year, they said you could only pay additional notes if the bank document in the capital structure would not allow you to dividend up cash to pay that interest."

The increase in PIK toggle notes may be linked to the fiscal cliff, Musicaro said.

About five PIK toggle note offerings priced in December ahead of the Dec. 31 deadline to stall $600 billion in spending cuts and tax hikes set to take effect in the new year, according to sources.

"With the fiscal cliff coming up, a lot of companies are paying themselves dividends, so PIK style is a good way to do that," Musicaro said. "Dividend tax rates are going up, so across all of finance, we've seen an increase in dividends this month."

The PIK toggle note deals with tightened language may drop off after the tax legislation is put into place, but looser bond covenants are likely to continue to be a trend in 2013, said Alexander Dill, head of covenant research at Moody's Investors Service.

"The economic environment is not necessarily going to change in 2013, and a lot of that seems to be driving the dynamics of covenant protection," Dill said. "We don't see the picture getting necessarily worse, but we don't see it getting necessarily better in 2013 because of the low-interest-rate environment."

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