The high-yield space is rife with chicanery, so be on your guard before you buy that block of bonds.
If you think this is media sensationalism, think twice. The warning comes from bond guru Martin Fridson, who’s been dubbed “the dean of high-yield debt.” He is currently CIO of Lehmann Livian Fridson Advisors LLC in New York, and spoke with Advisor.ca at the CFA Institute’s Annual Conference in Montreal.
Fridson says if you’re going to buy a high-yield bond, you absolutely must read the covenant, which lays out the terms of the issue.
“Covenants are deliberately written in opaque language,” he says. “That’s not by accident; it’s […] to make them hard to understand and to allow slippery practices at a later point. Basically, what you’re trying to protect yourself against is the company adding debt on top of you that’s more senior to you, [and] adding much more debt to the company so that the overall leverage is much greater than what you originally intended [when you made your investment].”
Read: Beware of bond covenants
He notes high-yield covenants are often so esoteric that fund managers, who themselves are bond experts, often hire specialized firms to find traps within covenants. “There are a lot of pitfalls. It’s unfortunate that covenants are written in that way […] because it’s an extra cost for investors” when they need to bring in outside help. Efforts to institute standardized covenants that dispense with the esoterics “have failed consistently and are likely to continue to fail, unfortunately.”
Why it happens
Fridson traces the problem back to the dynamics of bringing high-yield bonds to market.
The underwriters and investment bankers “present themselves as neutral referees, but they are inherently biased in favour of the issuer, because it’s the issuer who selects the bookrunning manager for the deal, and that’s how you make money—running the deal.”
At one time, an underwriter may have been able to claim that he or she is better able to underwrite the deal than someone else. “Now, for most deals for single-B or better issuers, […] there’s not much dispute about what the pricing should be, so it’s very hard to make a case that you are somehow going to get a better rate than with a competitor,” explains Fridson.
So how do underwriters try to one-up one another?
“The way you can compete is to say, ‘We have some lawyers and investment bankers […] and they’ve come up with some new gimmick in the covenants that will fool people. They won’t know what’s going on until after it’s been exercised against them. And we can get away with a few of these deals before people figure it out. So you should do your deal with us. So the company says, ‘Great; you’ve got the mandate to lead the deal.’ ”
That’s all legal, but you must be wondering: How can they get away with these shenanigans? Doesn’t it damage their reputations and become self-defeating?
No, says Fridson.
“[I]t’s an oligopoly. You only have a half-dozen underwriters doing most of the deals. It’s highly concentrated, and it has to be that way because to be an underwriter you need a team of analysts, investment bankers, traders, salespeople—there’s a lot of overhead to support. So unless you can get about a 10% share of the market, you can’t afford [it].”
And investors can’t effectively punish the underwriters and investment bankers. At most, says Fridson, they can say, “ ‘Because you’ve done something we consider to be underhanded we’re going to [put you in] the penalty box—we’re going to refuse to trade with you for the next month.’ Well, the investment bank doesn’t really care that much; it is important to [the investment bank’s] salesman who covers that money manager,” but the bank itself doesn’t make much money doing secondary trading, explains Fridson. So it’s not much of a punishment.
He adds that even if a money manager gives the investment bank a time-out, it’ll be brief. “I can’t leave you in the penalty box very long because I go through periods where there are huge inflows into [my] funds and I don’t have the option of staying in cash, because then my shareholders say, ‘I’m not going to pay you half a percent to manage a cash portfolio.’ ” In other words, a fund manager can’t conduct his or her ordinary business effectively if he or she excludes a player that does 15% of the market’s deals.
Bottom line, read the covenant before you buy a high-yield bond. And if you don’t have the chops to decode the riddle of the Sphinx, hire someone who does.