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Understated Outcomes of an Evolving Covenant Environment

The pandemic’s financial toll has been widespread, but a surprising silver lining has been the relatively short-lived corporate default wave. Default volumes were certainly elevated throughout 2020 but steadily declined over the last several months as risk-seeking capital rushed to meet companies’ liquidity shortfalls. Even more notable, defaults have been relatively rare among COVID-impacted businesses, with most default activity occurring in areas already struggling before the pandemic—not because of it. In fact, sectors most impacted by the COVID crisis have only accounted for 0.4% of high yield’s current 7.0% default rate. Instead, areas that have been the epicenter for bankruptcies over the last several years—notably energy and telecom—have accounted for close to 70% of bond defaults in 2020, despite only accounting for about 20% of the market. Certainly, actions taken by the Fed and Congress have done most of the heavy lifting in keeping defaults contained, but an underappreciated element has been the flexibility afforded corporate borrowers by the well-documented cov-lite trend.

Defaults Have Been Concentrated in Areas That Were Facing Trouble Before the Pandemic 
12-Month Par-Weighted High Yield Corporate Default Rate

Source: ICE BofA/S&P LCD/Artisan Partners. As of 31 December 2020. Par-weighted Default Rate represents the total dollar volume of defaulted securities compared to the total face amount of securities outstanding that could have defaulted.

Diluted creditor protections and increased cov-lite issuance over the last several years have allowed distressed borrowers to manage their way out of trouble and avoid technical default. With fewer contractual protections that limit a borrower’s ability to add debt, companies most disrupted by COVID have become increasingly creative in their ability to triage a standstill in revenues and declining liquidity. Stressed and distressed borrowers have looked beyond traditional revolver draws and equity injections, using loose credit agreements to negotiate creative capital solutions—often directly with lenders—to manage existing liabilities and defer defaults. For companies with unsustainable capital structures, these liquidity bridges only delay the inevitable before restructurings are required, but for strong businesses facing temporary pandemic-related issues, these transactions buy time to survive the crisis intact.

After a Sharp Increase in Q2 2020, Default Volumes Have Steadily Declined
High Yield Bonds, Leveraged Loans Default Volumes ($ Billions)

Source: JPMorgan/Artisan Partners. As of 31 December 2020.

Eroding debt-incurrence and lien-protection covenants have opened the door to a wide range of options for borrowers to introduce new liquidity into stressed capital structures. For issuers that may find it difficult to raise new second lien or unsecured debt due to already elevated leverage levels, a common transaction used by borrowers throughout the COVID crisis allows new lenders to step into the senior secured position by priming, or subordinating, existing senior debtholders through the introduction of super-senior secured debt. These transactions underscore the importance of a diligent covenant review process to thoroughly understand the potential positive and negative outcomes that may arise because of loose credit agreements.

These capital solutions have delivered both lenders and borrowers favorable outcomes: Borrowers have received a lifeline that gets them closer to the crisis’ conclusion, and in exchange, lenders have received higher incremental yields, more structural seniority and better credit protections. For opportunistic credit investors, these transactions provide the opportunity to engage with issuers to create a capital solution that provides companies enough runway to execute a turnaround and investors attractive risk-adjusted return potential.