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These 2 Debt Instruments Pose Peril to Millions of Investors

A billionaire says the search for yield is overriding credit judgment

by Bob Stokes
Updated: October 12, 2016

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[Editor's Note: The text version of the story is below.]

In a world of low and even negative rates, bond investors are so hungry for yield they're willing to accept high levels of risk.

For example, bond investors are increasingly embracing debt instruments known as covenant lite loans, which provide minimal protection should the issuer get into financial trouble.

Investors should pay close attention to this development, because this is exactly what happened before the 2007-2009 financial crisis.

Our April 2007 Elliott Wave Financial Forecast warned subscribers beforehand:

The only reason that the crisis has yet to spread to the corporate debt market in general is that lenders continue to slacken underwriting standards, just as they previously did in the mortgage sector. Consider, for instance, the latest boom instrument, a corporate product known as "covenant lite," bank loans that "subject borrowers to few of the usual performance requirements that have been standard in the past." Standard & Poor's says that $41 billion in lite loans have already been issued in 2007, a figure that is greater than that of the last 10 years combined.

Remember, cov-lite loans free the debt issuer from meeting normal fiscal disclosures and financial metrics, so the risk to lenders is high.

With that in mind, consider this (Bloomberg, Sept. 27):

Just 35 percent of new leveraged loans issued in 2016's first half had traditional covenants that require regular financial check-ups, compared with 100 percent in 2010.

A billionaire investor noted that "the fact that there are no covenants tells you that people are substituting yield for credit judgment."

But financial optimism is also reflected in the popularity of yet another high-risk debt instrument.

Here's a chart and commentary from our October Financial Forecast:

Another bond market revisitation from the last credit mania is the "red-hot" market for payment-in-kind (PIK) bonds. ... PIK bonds allow the issuer to pay interest in additional debt rather than cash. September is set to become the busiest month ever for PIK issuance, led by German auto component maker Schaeffler AG's $1.5 billion issue, the largest in history. Similar to the heightened risk associated with buying cov-lite loans, seasoned investors acknowledge the peril of buying PIK bonds.

As we've noted before, credit implosions develop when lenders relax credit standards and investors reach for yield.

This might well be the time to play it safe.

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