Moody’s, the US credit rating agency, is due on Wednesday to announce that it is creating a formal system to assess the strength of investor covenants attached to corporate bonds in both the US and Europe for the first time.
The move has been prompted by growing concern that investors are becoming increasingly vulnerable to unexpected losses on their bond holdings because they do not always understand the covenants protecting their rights.
The concerns have been partly triggered by the ultra-benign credit conditions in European and US markets, which have left investors less able to force issuers to include strong covenants protecting their rights.
However, another important factor is the ongoing explosion of private equity activity. In particular, as buyout groups acquire companies previously considered to be beyond their reach, a broader pool of bond investors are now being forced to consider the rights they do – or do not – enjoy in a leveraged takeover.
“A burgeoning leveraged buyout market has indicated a need for covenant assessments in Europe,” says Michael West, Moody’s managing director for European Corporate Finance.
“The increasing amounts of leverage in transactions make us concerned about investor protection in an adverse economy.”
Tracking the level of covenant protection that investors enjoy has traditionally been relatively difficult, since covenants can vary significantly between deals and crucial details are often contained in the fine print.
However, the key points typically covered in covenants include the degree of freedom a company enjoys in terms of disposing of its assets or selling itself to a new buyer, and the ability of investors to demand repayment of bonds if new instruments are issued or the credit rating of the issuer declines sharply – for example, due to a leveraged buyout.
Traditionally, investors have demanded that companies with sub-investment grade ratings use restrictive, investor-friendly covenants, because these issuers have been perceived to be most vulnerable to an LBO.
However, investors have generally not been able to demand restrictive covenants for investment grade bonds. This has left some investors nursing unexpected losses when investment grade companies have fallen victim to an LBO – as, for example, in a buyout of ISS, a Danish cleaning group, last year.
That has prompted all of the rating agencies to focus more intensively on covenants, although Moody’s is believed to be the first to introduce a formal system for measuring covenant strength.