Moody’s Warning Over Junk Bond Debt Covenant Quality

Moody’s went on to show that the average covenant quality score dropped to 4.36 last month from 3.84 in January. Moody’s five-point scale is based on a 1.0 as the strongest and 5.0 as the weakest.

Wednesday’s report said:

The average monthly score had improved from the prior record low of 4.26, set in October, although issuance in the past three months has been about half the level that accompanied the deterioration last autumn, making it difficult to draw a firm conclusion from the last month’s weakness.

February’s decline was driven largely by record weak scores for bonds rated single B at issuance and a near-record percentage of high-yield-lite bonds. The covenant quality of single B bonds fell to 4.24 from 3.77 in January, much weaker than the average of 3.64. And these bonds comprised 56% February’s issuance, higher than the 50% average.

Investors need to beware what this signifies over the longer term, because it means that investors in these junk bonds may have lower and lower recovery rates if there are defaults ahead. Those debt covenants being weak are better for the corporations issuing the debt, but they take power away from the creditors if those covenants are weak.