Moody's: High-yield bond covenant quality hit new low in January on deal surge

By Cristal Cody

Tupelo, Miss., Feb. 12 - Covenant quality for North American high-yield bonds slid to a new low in January, according to a Moody's Investors Service report released on Tuesday.

Moody's said its covenant quality index, which uses a five-point scale with five being the weakest, showed that covenant quality began to erode when it peaked at 3.4 in July and at the same time that high-yield bond issuance started to climb.

"Our three-month rolling average CQI deteriorated to 3.89 in January from 3.79 in December," Alexander Dill, head of covenant research at Moody's and author of the report, "Bond Covenant Quality Resumes Slide," said in a statement.

The single-month score in January was 4.08, down from 3.55 in December and the previous low of 4.06 in November, according to the report.

"December showed an uptick in covenant quality, even as PIK issuance surged with the approaching U.S. fiscal cliff deadline, but it was still weak," the report said. "In January, worsening protection against risky investments and leveraging, as reflected in subcomponent indices, contributed to overall deteriorating quality."

The drop in January's covenant protection mostly is due to an increase in "high-yield lite issuance," according to Moody's.

High-yield lite covenant packages, which lack a restricted payments and/or a debt-incurrence covenant, accounted for 34.6% of issuance in January, compared with 3.2% in December, Moody's said.

Netflix, Inc., Lear Corp. and Crown Americas LLC priced bonds with high-yield lite packages in January after the companies previously sold bonds with full high-yield covenant packages.

"This continues a recent trend of companies converting to high-yield lite packages from full high-yield packages," the Moody's report said. "In November, Sealed Air and Huntsman converted to high-yield lite."

Issuance of Ba-rated bonds, which generally have high-yield-lite covenant packages or full covenant packages with low covenant quality, also jumped to 58% of issuance in January, compared with an average 27% since Moody's began tracking covenant quality in January 2011.

Midstream oil & gas companies, which historically have offered low covenant quality, also helped "pull down January's average CQ score," the report said.

Three midstream oil and gas issues came to market in January from MarkWest Energy Partners, LP, which Moody's rated a covenant quality score of 4.52; Rockies Express Pipeline LLC, which was rated 5.00; and Atlas Pipeline Partners, LP, which was rated 4.11.

"Based on our database, weakening covenant scores show that investors are taking on more covenant risk despite less yield, as average spread to benchmarks tightened in the 2nd half of 2012, fueled by strong investor demand and record volume of HY issuances," the Moody's report said. "In comparison, the average benchmark spread of new bonds issued since October is near the same level as the first half of 2011, but our CQI shows much weaker covenants."

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