Secured Lending Booms

Cash-burning industries are using their most valuable assets to secure liquidity during the pandemic. Yield-hungry investors are happy to oblige.

The lush coconut palms and shady cabanas of Great Stirrup Cay welcomed cruise ship passengers until the Covid-19 pandemic froze the multibillion-dollar travel industry. The tiny island in the Bahamas is now a lifeboat for creditors instead. The tropical paradise’s owner, Norwegian Cruise Line, pledged it last year along with Harvest Caye off southern Belize, and two ships, as bond collateral for a $675 million loan.

“The pandemic saw stressed issuers like Carnival, Norwegian Cruise Line and United Airlines make creative use of their assets such as ships, islands and airplanes to raise liquidity when they needed it,” says Shweta Rao, UK-based senior director and head of Europe, Middle East and Africa (EMEA) Covenants at Reorg, a global financial and legal intelligence provider. Carnival used its fleet of cruise liners to secure high-yield notes; United, Delta and American Airlines pooled planes, spare engines, mileage programs, brands, slots, gates and routes; and AMC Entertainment collateralized its Odeon movie theaters. 

Global industries tapped bond markets for $3.3 trillion in 2020, according to estimates by S&P Global. Central banks intervened in support of ailing companies by buying corporate bonds, and the backstop opened the debt market to corporate junk bonds secured by strategic assets.

“As a reflection of continuing demand for new issuance, in 2020, high-yield volumes reached a post-financial crisis high in excess of €108 billion [$130.7 billion],” notes Alastair Gillespie, senior covenant analyst at Covenant Review. S&P Global estimates that central banks will keep interest rates at current levels through 2024; the agency forecast a decline of at least 4% in global nonfinancial issuance in 2021 after last year’s steep 35% increase.

Market pundits are cautiously optimistic about the growth of high-yield and leveraged loans for 2021. “A key reason for this appears to be monetary and fiscal support given by central banks and governments,” Rao says. “And an optimism that the same shall continue if required.”

“Issuance will likely continue at a healthy pace in 2021,” says Christina Padgett, associate managing director at Moody’s Investors Service, who is among those expecting a “healthy pace” of issuance in 2021. “Low rates should maintain investor demand for speculative grade,” she says. “Supply will come from mergers and acquisitions and new leveraged buyouts, which were somewhat constrained in 2020.”

Investors hunting for higher coupons in the present near-zero interest rate environment are betting that corporate issuers will emerge stronger from the coronavirus crisis once vaccines enable travel and hospitality to fully resume. To bridge the gap, corporations have offered coupons higher than the 7% average interest on most American high-yield notes. Last April, Carnival, the world’s largest cruise operator, guaranteed 11.5% interest on a $4 billion 2023 issuance. Norwegian Cruise Line has a 12.25% yield on its 2024 notes. Delta, United and American Airlines put liens on jets worth more than 1.6 times the total value of the loan to give creditors a buffer against losses.

“Point is, if primary markets were exuberant in the worst of times, it’s not a stretch to believe they will only become more exuberant as global economies recover,” says Peter Washkowitz, senior director and head of Americas Covenants at Reorg.

“Pick Your Poison” 

Establishing how much additional secured debt can share the collateral and who gets paid first in case of bankruptcy are the critical questions in secured lending. The purpose of covenants is to limit borrowers’ ability to issue additional debt, grant liens on assets, make certain payments and sell assets in order to minimize the risk of default.

But hungry-for-yield investors have lately veered in the direction of being more accommodating, rather than less.

“Over the past few years, covenants in new leveraged loans and high yield have traveled in one direction only,” says Rao: “to become more accommodating for the issuer, generally to the detriment of bondholders and lenders. Surprising to some, this direction of travel was not reversed or even halted by the pandemic. Covenant erosion in 2020 for primary market issuances continued unabated.”

Borrower-friendly covenant terms have remained largely unchanged during the pandemic. “From the companies’ perspective, the covenants are functioning as envisioned, giving them self-determination when facing distress,” says Evan Friedman, senior vice president, manager and head of Covenant Research at Moody’s.

Exceptions to limitations, such as the ability to transfer collateral away from creditors, have become more frequent during Covid-19, Rao says.

In 2017, US retailer J. Crew shocked investors by moving pledged collateral into an unrestricted subsidiary to raise additional cash. Last May, UK sports car maker McLaren Automotive sought to transfer its heritage car collection and headquarters away from existing creditors. But bondholders fought back, and the dispute was eventually resolved by mutual concessions.

“Another clear trend we have identified is that issuers are creating more documentary flexibility for themselves, to prevent a default in a stressed scenario,” Rao says.

For example, companies have introduced “super-grower” baskets: The cap on debt increases when Ebitda rises but holds steady when Ebitda falls. Another new feature, the “dividend-to-debt toggle,” or “pick your poison,” allows borrowers to convert their restricted payments capacity into additional debt, often secured, according to Reorg’s research.

Protections Weakening

Issuers based in emerging economies generally must offer more-stringent protective-covenant packages than their counterparts in North America and other parts of Europe, the Middle East and Asia.

“However, there has been a steady decline in covenant quality in emerging market bonds,” says Jake Avayou, vice president and senior covenant officer at Moody’s in Singapore, “specifically in terms of companies loosening their debt covenants.”

The US is the largest issuer of corporate bonds globally, according to S&P Global, followed by Europe, while China leads among emerging markets. Unusual assets have been used to secure bonds more often in the US than Europe thus far during the pandemic, Rao says; meanwhile, Avayou notes, debt-ratio thresholds have been declining toward the standard seen for North American and EMEA bonds.

Yet, Covid-19 travel restrictions continue to erode cash. Carnival says it has enough fuel to stay afloat in 2021; and Reorg estimates American Airlines, Delta and United have a liquidity runway of little over a year. All, however, expect to continue to burn cash in the first months of 2021. While default rates have remained below previous peaks, the risk of downgrades remains high as the global economy slowly heals, the International Monetary Fund (IMF) warns.

“I absolutely see a risk of the value of pledged aircraft and cruise lines declining as travel continues to be impacted by coronavirus,” says Reorg’s Washkowitz.

Adds Pete Trombetta, vice president and lodging and cruise analyst at Moody’s, “It’s very likely that ships being sold today are discounted from the value placed on them a year ago.”

The number of potential fallen angels—issuers downgraded to a BBB- rating and a negative outlook—has tripled since the beginning of the pandemic, according to the IMF’s January Global Financial Stability Update. A recent series of defaults by Chinese state-owned companies make addressing financial vulnerabilities a priority, the IMF cautions.

If the global economy does not recover fast enough, such concerns may loom much larger. “The existential anxiety creditors have been increasingly facing over the past few years stems from the inability to predict which camp their borrowers will fall into,” says Moody’s Friedman.