Sept 17 (Askume) – When U.S. building materials supplier Wilsonart issued junk bonds this summer to raise $500 million for an acquisition, a research firm warned potential investors that the terms of the deal offered them little protection.
Research firm Covenant Review wrote in a commentary seen by Askume that the terms of the bonds would allow the company to later transfer its valuable assets to another entity and raise more capital, which could provide additional funds for investing in the bonds to protect investors from losses.
The warning comes amid growing concerns in debt markets as more companies are exploiting similar vulnerabilities to borrow more with the same assets, a practice commonly known as liability management.
This allows some creditors to receive preferential treatment over others, leading to so-called creditor-on-creditor violence. This year, things got so bad that some creditors banded together to take retaliatory action.
So, after the warning, how do investors feel about Wilsonart’s offer? They took it immediately.
Wilsonart did not immediately respond to a request for comment.
Wilsonart’s ability to raise capital highlights a paradoxical trend in U.S. debt markets: While investors are suffering the consequences of weak covenants that have allowed most companies to raise funds without significant headwinds, bankers, lawyers and investors say they sold new paper with the same flaws.
Market sources say this is due to a shortage of supply of junk-rated bonds, the need for higher yields before the Fed starts cutting interest rates, and a divergence of interests between the largest lenders and smaller investors.
Peter Tol, global head of fixed income syndicate at Barclays, said: “Investors face a tough choice: should I hold cash and not buy bonds or loans because incomplete documentation could impact my returns. “The drawback is that most of the borrowing is currently to pay off old debt.
Many bankers and analysts estimate that as much as 90% of high-yield bonds and loans entering the market are sold with weak investor protections, amid growing concerns that troubled companies will not be able to repay debts on time, or that they are simply taking advantage of the debt.
Barclays research shows that more than 90% of the loans in the Morningstar LSTA Leveraged Loan Index are now “covenant-light,” meaning they lack maintenance covenants, a metric that has risen sharply since the 2008 financial crisis.
Liability management practices (LMEs) come in many forms, but the most common strategy involves companies transferring valuable assets to subsidiaries. The subsidiary then raises debt from several new and existing investors in a side deal. The cash is then sent back to the parent company in the form of intercompany loans.
The redundancy deals give new lenders first priority in claiming a company’s assets if it goes bankrupt, leaving existing investors behind and increasing their potential losses in the event of a default.
High-yield bonds and loans bought by investors are distributed to funds and then sold to retail and large institutional investors, who may suffer losses or lose their money due to weak contractual protections and the mysterious nature of the LME.
A heartbreaking exchange
JPMorgan Chase said 28 companies have so far completed the replacement of non-performing assets in 2024, totaling US$35 billion, the second-largest amount on record. Their number is only expected to grow.
Moody’s said it assesses that about 13.5%, or $400 billion, of its more than $3 trillion in junk debt faces a high risk of default within the next 12 months, forcing most of it to resort to restrictive liability management practices. There is little protection.
Investors are forced to consider ways to increase their claim on a company’s assets. Bankers and lawyers say many creditors are signing partnership agreements or private legal arrangements to increase their negotiating power and prevent rivals from signing side agreements without their knowledge.
Steven Oh, global head of credit and fixed income at asset management firm PineBridge Investments, said investors are caught in a “prisoner’s dilemma.”
“Enter into a side business with the company to expand your interests, or join forces with others to prevent others from working with the company,” Oh said.
In some cases, investors will even boycott documents and refuse to buy new loans unless the borrower agrees to include provisions that prevent it from defrauding existing creditors. Moody’s noted in April that Thrive and two other borrowers faced such headwinds.
However, market sources said such protests are rare.The situation arose again in early September, when Clayton, Dubilier & Rice (CD&R) sold $400 million of junk-rated bonds through Fiesta Purchasing.
Covenant Review issued a further market warning, urging investors to reject the legal provisions because it would restrict the company’s ability to issue debt through subsidiaries to “ludicrous extremes”.
A few days later, he reported the same error in a new $700 million bond offering by Focus Financial Partners, but when the bonds were sized and priced on September 9 and 10, he realized there was probably a change in their language.
CD&R declined to comment, and Focus Financial did not respond to a request for comment.
Scott Josefsberg, director of high yield research at Covenant Review, said the changes show that covenant security can be improved if investors are willing to try, but they are still a far cry from being significant changes.
“Most bonds and loans do not have LME protection and can be easily sold,” Josefsberg said.
