Much was written in late 2007 about the increased issuance of covenant-light loans and “PIK-toggle” (payment in kind loans) bonds. These are securities that shift more risk onto bondholders, giving borrowers more flexibility and allowing for less financial discipline. Covenant-light loans typically pare back some of the fundamental covenants put in place to help lenders detect early signs of borrower weakness.
“PIK-toggles” afford the borrower the opportunity to forgo cash interest payments to the lender until the refinancing or maturity date. These loans historically came with significantly higher risk premiums than are seen today.
Unfortunately, since 2013, these loans have made quite the comeback and, as the chart below indicates, covenant quality has been steadily worsening—a higher number means lower protection—as a result.
So, with yields near historical lows, bonds pricing in a low default rate and issuers taking advantage of investor demand, the overall quality of debt being issued continues to deteriorate.
Investors are unknowingly, by and large, taking on significantly greater risk without being paid for it. Lurking underneath the low quality dilemma is the potential for a liquidity-driven rout should investors look to exit en masse.
Restrictions imposed on banks via Basel and Dodd-Frank legislation have tied the hands of primary dealers in this space. These dealers have historically provided most of the liquidity in the market to retail as well as institutional investors. Restrictions on primary dealer holdings are already apparent and have led to much choppier price action in junk bonds. The fallout of these changes is this: Any large-scale selling could be met with a significant gap down in price before interested buyers enter the market.