- The average covenant quality of green and sustainable high-yield bonds in Europe stood at 4.3 versus 4.04 for conventional issues last year, according to Moody’s (with 1 being the best and 5 the worst).
- Issuance of GSS junk bonds is largely coming from private equity-backed companies, which have been incorporating weaker covenants.
- There is evidence that some investors are warier of such deals, while US fund house Nuveen recommends close due diligence and feels covenant weakness will persist.
Investors have been piling into green and sustainable high-yield, or junk, bonds despite them containing weaker covenants than their conventional counterparts – but there is evidence emerging of buyer’s remorse.
High-yield green, social and sustainability (GSS) – and sustainability-linked – bonds sold in Europe last year had weaker covenants than plain-vanilla junk debt, according to a 14 June report from rating agency Moody’s.
Covenants, the terms of agreement between issuer and bondholder, are designed to protect the interests of both parties. Moves to weaken them favour the issuer over the buyer, theoretically increasing a bond’s investment risk.
Moody’s rates covenant quality from 1 (the best) to 5, and the average score for the 26 GSS high-yield bonds issued in 2021 was 4.3, versus 4.04 for the 88 non-green equivalents. Only two GSS high-yield bonds were sold in the first quarter of this year.
Private equity driving weak covenants
Private equity firms are largely responsible for the disparity in covenant quality, according to the report. “This outcome is linked to their issuers: nearly 70% of green bonds were inaugural issues by private equity-backed companies, compared with 36% of non-green bonds,” it says. Moody’s uses the label ‘green’ as a catch-all for GSS and sustainability-linked debt.
The traditional argument for why private equity managers push for weaker covenants is that they understand the company properly, says Lisa Gundy, senior covenant officer at Moody’s in London and lead author of the report.
“The sponsors are very much focused on making sure that there’s flexibility for them to be able to manage the businesses they own in the way that they feel is required,” she adds.
One private equity executive told Capital Monitor: “It’s unsurprising that we should seek to maximise the flexibility in our documents, as other sponsors do.”
However, this approach could pose an issue if, for instance, the leverage – the amount of debt a company has in its capital structure – were to increase dramatically, Gundy says. “If you are buying a bond issued by a company, its level of debt should remain reasonably stable.”
The aggressive drafting on covenants is designed to avoid breaches, which means a default is unlikely, Gundy says. But in the event of a breach, she adds, it would have to be communicated to the market, and investors would decide what happened next. Typically, the bond would have to be repaid in full.
Green bond buyer's remorse?
The weakest covenant scores in the report are ascribed to a €460m sustainability-linked bond issued by Basel-based speciality chemical business Herens Midco in August last year. It matures in 2029 and has a coupon of 5.25%.
Moody’s rated the covenants on the bonds at 4.95 and, in a snapshot report after the issue priced, it highlighted the weakness of all of its covenants individually. The leverage was a particular red flag, at 6.2 times earnings before interest, taxes, depreciation and amortisation (Ebitda), which Moody’s calculated could rise to as much as 16.1 times.
If a company is being bought at a leverage of, say, five times Ebitda, “you do not want them to be able to incur debt materially above and beyond that level”, Gundy says.
Following the publication of the Moody’s report, the bond’s price has fallen. On 27 June it was trading at 64.77 cents to the dollar and yielding 11.82%.
Originally called Lonza Speciality Ingredients and rebranded in October last year as Arxada, the parent company Herens Midco was spun off from biotechnology manufacturer Lonza for SFr4.2bn ($4.4bn) in February last year to Boston-based private investment firm Bain Capital and British private equity firm Cinven.
But neither the covenants on the 2029 debt nor Herens Midco’s $350m 4.75% sustainability-linked 2028-maturity bonds, which were sold in May last year, have found favour with analysts or the market.
US credit intelligence company Reorg in April last year called the covenant package on the 2028 bonds “aggressive”. Like the Herens Midco issue, they have since traded down. On 27 June they were trading at 75.7 and yielding 10.6%.
Both Bain and Cinven declined to comment on the bonds’ covenants.
Caveat emptor
Stephen Liberatore, lead portfolio manager for US asset manager Nuveen’s fixed income strategies that incorporate ESG criteria and impact investments, has noticed weaker covenants on GSS high-yield bonds and is not surprised that private equity firms are trying to push boundaries. It is their “primary goal” to “maximise the balance sheet and maximise capital structure to their advantage”, he says.
Deals that might not have gained as much interest in the past because of how they are structured, he adds, are now being snapped up because of that additional demand.
And Liberatore thinks weaker structures are here to stay for green debt. There is rising demand for GSS bond issuance, driven by asset managers that want to be perceived as being green or responsible.
On top of this is investor appetite for yield and diversification.
“Asset managers are always looking for further diversification and, in the high-yield space, anything that can get away from the fossil fuel industry,” Liberatore says, noting that many fossil fuel companies are junk debt issuers.
Further driving demand is the fact that there were no high-yield GSS bond sales of any type in Europe in 2020, and this year has seen negligible issuance thanks to interest rate uncertainty and geopolitical worries caused by Russia’s invasion of Ukraine.
So when markets fully reopen, covenant quality is expected to remain an issue. As Liberatore says: “The longer a credit cycle goes, the weaker those covenants get.”
Ultimately, he views it as a case of ‘caveat emptor’. “We have to be continually diligent in every transaction we look at,” he says, GSS bonds or otherwise.
Concerns over covenants may well drive some investors to further step up their scrutiny of GSS and sustainability-linked bonds, amid scepticism in some quarters over transparency of how proceeds will be used or the credibility and ambition of key performance indicators (KPIs).
All but two of the GSS bonds issued in 2021 were sustainability-linked, says the Moody’s report, and none of them has had to meet a target for a KPI because most issuers have at least three years to achieve their sustainability goals.
“Questions remain as to whether the size of the step-ups and the strength of the testing parameters meaningfully incentivise issuers to achieve sustainability targets,” the report says.
It may be that tighter regulation – such as making Europe’s green bond standard mandatory for issuers – will help encourage best practice. But in any case investors would be well advised to look more closely at the small print.
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