Creditors are increasingly concerned about unfair debt deals and are adding protective clauses to safeguard their interests, as seen in R.R. Donnelley’s recent $1.5 billion bond issuance. 

The quality of covenants has weakened over the past decade, offering less protection to creditors, especially in tough economic conditions. 

This shift signals growing fears of bankruptcy and highlights the need for caution in credit markets, as companies may favor certain lenders, leaving others exposed.

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It is never a good sign when creditors start thinking about bankruptcy scenarios and finding ways to protect their money over other creditors.

Unfortunately, creditor-on-creditor fights are starting to take place more frequently nowadays.

For instance, it happened in July when a $1.5 billion bond was issued by R.R. Donnelley, a formerly public printing and packaging firm.

The company went to the bond market to raise money for a buyout and investors took a stand against unfair practices between creditors.

So, the company had to change the bond documents to include new, wide-ranging rules that are designed to prevent future debt deals that could favor some creditors over others.

These rules ease the fear of creditors as it ensures protection against further unfair debt arrangements.

At first glance, this may seem good for creditors, however this is never a good sign for credit overall.

One way for creditors to protect themselves in a debt deal is through covenants.

They are the legally binding clauses included in debt deals to protect the best interests of creditors.

Typically, covenants condition certain actions borrowers must take or avoid, to ensure repayment of the debt.

And in the event of a violation known as a “covenant breach,” the creditors can get certain rights to intervene.

Covenants were much stronger and more protective several decades ago, especially before the Great Recession.

After that, in a near-zero interest and high corporate debt demand environment, lenders found it difficult to enforce strict loans to corporations.

To attract more borrowers, lenders started offering fewer and less restrictive covenants known as “covenant-lite” bonds, which are more favorable for companies as they provide operational flexibility.

Yet, they provide limited protection for lenders, making it riskier from a creditor’s perspective.

Since 2011, the covenant quality has been in a downward trend and the picture started to get darker in the first quarter of 2014.

The quality of covenants has been consistently below what credit-ratings agency Moody’s considers the weakest protection level.

Excluding some short-term outliers, this has been the case for the whole decade.

Take a look…

Although it seems alarming, this is not always a big deal, especially in a strong economy.

However, it can lead to serious problems when the economy worsens, and companies start to struggle to pay debts.

Unprotective covenants leave creditors with limited options when companies go bankrupt and possibly let creditors return empty-handed from a debt deal.

In addition, weaker covenants can make it easier for companies to take on more debt or refinance in ways that favor certain lenders over others, as we said before.

Investors think that getting involved in a credit deal is riskier than before…

That’s why they demand protection… and since corporations are having a hard time finding debt, they become obliged to comply with creditor demand.

The R.R. Donnelley bond deal was the first bullet in the credit space, and many more similar deals are expected to happen after that.

It is good that creditors took a stand to protect their money and can succeed.

However, the introduction of new protective clauses by lenders signals they are highly worried about a wave of bankruptcies and are acting swiftly to protect themselves.

Things can go south really fast. That’s why investors should be careful when getting into credit markets.

Best regards,

Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research