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Bond Market Shenanigans – should you be worried?

04112019_Narrow Road Capital

Bond Market Shenanigans – should you be worried?

Our very good friend the founder and CIO of Narrow Road Capital, Jonathan Rochford, writes a terrific monthly missive about the goings-on in financial markets around the globe.

The October report had this to say about trend in corporate bonds…

“There’s something of an ongoing battle between journalists looking to write a sensational article about US high yield debt and fund managers saying that their investments in the sector are fine. For instance, journalists have been (mostly correctly) pointing out that covenant lite loans present a substantial risk whilst some fund managers (mostly incorrectly) respond that covenants are overstated as a form of protection with other avenues used to contain the risk in the loans they are making. This month there’s been a few more articles warning of increasing risk which should have gotten a lot more attention than they did.

“Like covenant lite, earnings add-backs are a toxic development that will make the next downturn far worse than it would otherwise be. Add-backs occur when company management and private equity sponsors make claims that earnings are understated due to one off events, therefore earnings (typically measured by EBITDA) should be adjusted higher with losses from the negative incidents added back to the EBITDA line. This could be restructuring costs or acquisition costs, or in more egregious cases expectations of future earnings growth from opening new stores or acquiring new customers. Sometimes this is for a short window such as one year, other cases have given the company substantial leeway to inflate earnings over several years.

“The impact is that earnings for covenant testing purposes are far higher than they actually were, resulting in a covenant breach being avoided when it would have otherwise occurred. What used to be small, one-off adjustments are now nearly doubling EBITDA for B rated companies for testing purposes. This means that by the time a covenant breach actually occurs, the equity value is likely to be gone and the shareholders are far less likely to inject additional equity. It also means that the publicly reported leverage multiples (e.g. debt is six times EBITDA) can be massively understated, making historical comparisons an apples and oranges situation. Those who argue that leverage levels today are far lower than in 2006/7 are on very shaky ground.”

You can find out more about Narrow Road Capital and read the full October Memo here.


Roger is the Founder and Chief Investment Officer of Montgomery Investment Management. Roger brings more than two decades of investment and financial market experience, knowledge and relationships to bear in his role as Chief Investment Officer. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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