Beware This New Hidden Risk in Your Portfolio

On its face, bond investing is simple. You lend money to a company for a certain period of time, accepting a certain interest rate for your trouble. When the bond matures, the company pays you back.

What makes bond investing a lot more complicated is what happens when things go wrong. Ideally, what you want as an investor is maximum protection from adverse consequences. But with bond yields having come down so far and with so much investor demand for corporate bonds, especially in the high-yield sector, some of the protections that bond investors have come to rely on are starting to disappear.

The ins and outs of bond protection
Bond investors make much different demands on companies than stock investors do. When you own a stock, you have a clear understanding that the amount of power you have over the company is extremely limited. You're last in line to receive anything from the company in the event of a liquidation, and more often than not, adverse events like bankruptcy will entirely wipe shareholders out. Although shareholders may have the right to vote on certain major events, such as a proposed acquisition, they have little ability to drive ordinary corporate policy.

By contrast, bonds usually come with covenants that give bondholders rights to take action if the company doesn't meet certain conditions. Here's a short list of common provisions that you'll find among bond covenants:

• Change of control. In order to protect bondholders from a leveraged buyout or other acquisitions that involve a massive increase in the amount of debt outstanding, some bonds have covenants requiring accelerated repayment in the event of a merger or acquisition or that simply forbid such transactions entirely. This has been an issue with Dell's (DELL +0.00%) bonds recently, as they apparently don't include change-of-control covenants and thus plunged on fears that a massive increase in debt from the proposed leveraged buyout would reduce their quality substantially.
• What constitutes default. Clearly, not paying interest or principal when due is a default event. But any number of other provisions can qualify as default events, ranging from certain levels of debt-to-equity ratios or interest coverage to a bond-rating downgrade or other adverse impact on credit quality. In turn, once a default condition exists, it can give bondholders remedies that they don't otherwise have.

With bond indentures and other materials extending for hundreds of pages in some cases, it's complicated to understand all the protections a bond can offer. But knowing that they're there can give you assurances about how they'll perform if something goes wrong.

Deteriorating quality
Unfortunately, more companies are starting to negotiate weaker covenants and other unfavorable attributes that aren't as generous to bondholders. For instance, Moody's said earlier this week that bond quality in January hit an all-time low. The report noted that many new bonds, including issues from Netflix (NFLX +0.01%) and aircraft manufacturer Lear (LEA +0.00%), lack covenants governing certain restricted payments and incurring additional debt. Overall, more than half of bonds issued in January got a rating of Ba, which tend to have weaker covenants, compared to just over a quarter on average over the past two years.

Moreover, so-called payment-in-kind bonds are starting to get more popular as well. Last year, for instance, a unit of Goldman Sachs (GS +0.00%) arranged to have bonds issued to finance its buyout of TransUnion that had a payment-in-kind toggle option. These securities don't pay cash interest, instead issuing additional bonds. Obviously, these bonds have less-demanding cash-flow requirements for issuers, but they leave bondholders with increasing exposure to an issuer even if its credit condition erodes.

Be careful out there
When you're desperate for income, you may be willing to accept conditions you wouldn't ordinarily take. But with the risks already involved in lower-quality bonds, accepting weak covenants or payment in kind can leave you unprotected when things go wrong. By fully understanding what's involved, you can better assess whether the higher income is worth the risk you take.