Monday, June 10, 2013

Honey-I Shrunk the Covenants

A booming leveraged loan driven by yield hungry bank and non bank investors is supporting private equity transactions (Market ). Leveraged loans are also benefitting from a shift away from related high yield bonds into loans given their relative interest rate credit risk superiority. These developments are reflected in falling yields and looser terms and conditions for leveraged loans. This is especially true for loans with minimal covenant protection otherwise known as covenant-lite, which now represent more than 50% of the non-investment grade leveraged loan market new issuance year-to-date. Bank regulators have expressed their concerns over weak terms and covenant- lite loans (FDIC). Covenant-lite supporters dismiss such concerns.

Covenant-lite loans have minimal financial maintenance restriction. They are similar to pre-crisis “no doc” mortgage loans. Typical financial covenants require a debtor to maintain a certain multiple of earnings to interest expense to protect against default risk. An additional leverage covenant, expressed as a ratio of debt to equity, is included to provide a cushion limiting the creditor’s loss in event of default. A well designed covenant package allows creditors to preserve the original credit quality of the transaction. It allows them to force a loan restructuring should the debtor’s performance decline while there is still sufficient remaining debtor enterprise value to cover the loan. Thus, covenants serve surveillance and control functions in loan agreements.

Non bank investors represent the largest investor class in leveraged loans. Unlike banks, they place reduced reliance on covenant protection. Rather, they depend on the ability to liquidate their positions in the loan secondary trading market should they become uncomfortable with the debtor’s performance. Unfortunately, as many investors learned during the 2008/2009 crisis, liquidity is not always there when you need it. Thus, secondary market liquidity should be viewed as a complement to and not a substitute for structural protection provided by covenants.

Covenant- lite proponents contend that covenants provide limited protection. This is based on a 2011 study showing recovery rates for covenant lite loans issued in the 2005/2007 time period to be similar to other loans (Moody's Report). The reason given for this surprising performance is that recovery rates depend more on initial junior capital support, equity and subordinated debt, than on covenants, which protect against future erosion of the support. Unfortunately, this explanation is suspect for several reasons.

It is based on a limited sample covering one short time period. As the study notes, extrapolating from such a sample is very dangerous. Also, keep in mind the massive Federal Reserve liquidity intervention during since the financial crisis, which supported the rapid recovery of financial markets. This allowed many troubled firms to restructure their loans by refinancing. This may mask the performance characteristics of covenant- lite loans as they were never seriously tested against deteriorating collateral values and changing debtor behavior. Bottom line, there is no iron law that future covenant-lite recoveries will be as favorable in the next downturn. Market conditions, Federal Reserve support (e.g. Quantitative Easing) and underwriting standards can change quickly leading to vastly different recovery experiences. Investors need to examine the entire package-issuer quality (e.g. cash flow and junior capital cushion), instrument terms and conditions (e.g. covenants), yield, and market conditions when evaluating loans.

Consequently, the continued attractiveness of covent-lite loans depends. Knowing what they depend on is what separates the adults from the children. The current market cycle characterized by investors reaching for yield in a low rate environment has shifted the risk- reward dynamics in the issuer’s favor. This is reflected in lower quality issuers, looser terms and compressed yields. Risk is being priced for the perfect calm. We may, however, be facing a storm with the coming end of Federal Reserve QE resulting in potentially violent market changes. Investors should beware of these facts as we enter the adults only swim time in the leveraged loan market when considering covenant-lite loans.


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