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Fridson: High Yield Bond Covenant Quality See Record Plunge in August

The covenant quality of high-yield new issues suffered its biggest month-over-month decline ever in August. That plunge brought quality almost to the weakest covenant quality score on record. On a scale of 1 (strongest) to 5 (weakest), the FridsonVision version deteriorated by 0.73 points, to 4.59, from July’s 3.86 (see chart below). The worst score ever recorded was just a hairsbreadth worse, at 4.61 (June 2015).

hy cov quality

To provide background, “Covenant quality decline reexamined” (LCD News, Oct. 1, 2013) describes how we modify the Moody’s CQ Index to remove noise arising from month-to-month changes in the calendar’s ratings mix. On average, covenants are stronger on triple-Cs than on single-Bs, and stronger on single-Bs than on double-Bs. Therefore, for example, if issuance shifts downward in ratings mix in a given month, without covenant quality changing within any of the rating categories, the Moody’s CQ Index will show a spurious improvement. We eliminate such false signals by holding the ratings mix constant at an average calculated over a historical observation period.

In August, Moody’s version of the index worsened by 0.49 points, to 4.54, from July’s 4.05. The rating agency’s slightly more upbeat score (4.54 versus FridsonVision’s 4.59) reflected the distorting impact of a below-average concentration of issuance in the Ba category in August (24.0% versus historical mean of 32.4%). That effect was partially offset by a below-average concentration in Caa issues (20.0% versus a historical mean of 18.6%).

August’s precipitous month-over-month drop in covenant quality resulted from an across-the-board worsening in each rating category. By rating, the July and August average scores were as follows:

In short, issuers took full advantage of the shift in market conditions in their favor, as evidenced by a pickup in primary activity, from just 13 issues in July to 25 in August.

An across-the-board deterioration similar to last month’s contributed to the all-time record one-month plunge in the Moody’s version of the covenant quality index—0.76 percentage points in May 2016. That number was exaggerated by a large month-over-month increase in Ba concentration. Filtering out that effect, the FridsonVision series showed a deterioration of 0.68 points in May 2016, somewhat short of the record of 0.73 points posted in August 2017.

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