Delegates at Xtract Research's inaugural Covenant Forum lobbed questions at panelists consisting of whether the fixed income market is entering a new phase in interpreting covenants and how far the financial pledges have changed over the years.
The panel of five, who hailed from firms such as Marathon Asset Management and JP Morgan, were unanimous that both questions were inextricably tied. In response, it was explained that over the last decade, both a very low interest and corporate default rate environment served as the impetus for underwriters, lawyers and sponsors to push the envelope in diminishing covenant safeguards. Couple that with an investor base willing to take on additional risk in the search for yield results in covenants becoming continuously looser.
Panelists further explained, historically, double-digit interest rates and the importance of credit ratings shaped covenant creation more than anything else. Today, aforementioned market conditions dictate the language that is to be used to determine covenant packages for different issuers. Borrowers and issuers whose debt symbolizes great returns for yield-starved investors can fight for looser covenants, despite what their credit rating might be. The conundrum is that debt investors can’t push back against this because other investors will probably accept looser covenant terms. This sea change is really a new way of interpreting covenants, as they are now used by capital-producing companies to bargain for less restrictive covenants, allowing for more risks, whereas covenants used to be dictated by investors.
Another question that arose addressed universal understanding of transparency in the market. The panel responded by saying that there was in fact evidence of the opposite. The sharp changes in market prices are evident of a lack of transparency. There is no clear indication that borrowers always know what they can and cannot do. It relates to depth of credit agreements and why people are surprised by events that show what borrowers can do.
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