By constructing an overall "covenant protection index", the report suggests that bond investors in their search for yield have overall traded governance rights for higher expected returns. This shift also seems to be associated with higher risk-taking. The report ends with a discussion about the scope for institutional changes that may build a larger community of truly informed and motivated bond investors.
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IPE: OECD warns over ‘aggressive interpretation’ of bond covenants
The growth of non-bank lending and activist hedge funds in the fixed income space must be followed by the emergence of “informed and motivated” bond holders if smaller companies are to continue borrowing, the OECD suggests.
In a paper charting the development of the corporate bond market since 2000 – in which the authors found a 600% increase in non-investment grade debt over the following 13 years – the OECD noted the recent emergence of activist investors pursuing an “aggressive interpretation of established bond covenants”. The authors noted that such investors – often hedge funds – filed default notices for even the most minor covenant violation, only to then negotiate even more favourable terms. “This kind of bondholder engagement, aiming at windfall gains, is a departure from the traditional role of large institutional bondholders who usually limit their engagement to governing the risk and participating in restructurings and recovery of losses.”
The OECD noted that the differing approaches were of course down to the business models employed by investors – the long-term approach favoured by pension funds compared to the more short-termist hedge fund business model. “It remains to be seen if larger and more mature bond markets will develop a middle ground between total passivity and aggressive activism. “In an era of non-bank financial intermediation, the formation of such a community of informed and motivated financiers may be of particular importance for supporting the critical segment of medium-sized growth companies,” the paper said.
The authors also noted that investors had gradually come to accept a greater number of high-yield bonds, with “less stringent” covenants becoming a more common feature. The increased risk appetite is backed up by a recent survey that found record issuances of high-yield debt in Europe.
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