A Catch-22 in the Credit Markets

This morning, HCA announced they were intending to issue $1 billion of notes (split between secured and unsecured tranches). Mind you these bonds had no restricted payment basket covenants or unsecured debt incurrence covenants. The talk around 3:30PM was 6.375-6.5% on the secured 1st lien tranche and 7.375%-7.5% on the senior unsecured tranche. This talk was sent out by the JPM (lead book runner) sales team with indicated books closing at 4:30PM

Instead, HCA issued $5 billion (!) or a 5x up-size on deal at the wide end of talks. This has to be some sort of record for an up-size. The bonds went out 100.5 - 101.25 for the 6.5% and 100.5 - 101 on the unsecured 7.5%.

I forgot to point out that HCA's equity dropped 20% yesterday...

To me, the reasons investors are buying this offering is that HCA's paper is some of the most liquid in the high yield universe, it is well followed across the street, it is a very large complex with nearly $15B of market cap beneath you, and its one of those credits you won't (in theory) get killed in and should tighten if high yield spreads on the whole tighten. Are you going to make a ton of money here? Absolutely not. But you aren't going to lose a lot of money, and can allocate lots of capital to this deal and feel ok about it if you are a high yield manager who is awash in cash from coupons, calls, and maturing debts.

With all that said, one of the most frustrating aspects of investing in primary high yield credit is that the best issuers, except in very rare cases, have the worst covenants in their deals. Take this deal for instance, and forget about the upsizing; could a marginal, unknown issuer come to market with an unsecured piece of paper without restricted payment covenants or debt incurrence covenants? They could try, but the underwriter would be stuck holding the bag.

Maybe I am in the minority here, but I have passed on many deals of very well run companies that deserve premium equity valuations (i.e. of high returns on capital, significant barriers to entry, recurring revenue streams, etc) due to poorly structured covenants underpinning the deal. Call me overly conservative, but if an indenture is structured to allow a company the ability to screw over creditors and lenders, management and equity investors will most surely step up to the plate to do just that when it fits their needs.

In my opinion, when deals like this get struck investors are less focused on the downside and more focused on the potential return of a deal. This is myopic thinking that leads to excess risk taking across the corporate credit spectrum. Unfortunately, when the world is rosy, no one really cares about covenants.

Adding insult to injury, because "better" companies in theory fare downturns with less operational pain than weaker companies, it can be sometimes difficult to really see if weaker structures do lead to spread under performance. With that said, when investors incorrectly surmise the quality of an issuer with a weak covenant package, prices will most assuredly fall dramatically and an investor may have exposed himself to a permanent loss of capital.

In bearish markets, underwriters will strengthen covenant packages to attract investors to new high yield offerings when capital is scarce and precious. This is the time when investors, especially those that HAVE to play on the primary side, should be backing up the truck. This is not that time. Instead, today, I'm trying to thread the needle with purchasing high quality companies, with significant asset coverage, and reasonable covenants at yields above the overall market. I've found a few deals here and there that I believe investors misunderstood during the marketing process or were too small for investors to really get excited about. It keeps me busy while I pore through the secondary market looking for event-driven opportunities with a catalyst and a favorable upside / downside dynamic.