The Heavy Burden of Covenant-Lite

The 2013 issuance of covenant-lite leveraged loans exceeded the combined prior issuance of all covenant-lite facilities. The 2014 issuance is on a pace to break the record. Covenant-lite is now the standard in the syndicated leveraged loan market. Its attraction to issuers is oblivious - flexibility. Investors are supposedly attracted by higher incremental spreads and its favorable performance through the financial crisis. As they say, however, past performance is no guaranty of future performance.

The attached highlights My investor covenant-lite concerns:

1)     The ability of debtors to re-lever their firms to pay special dividends while loans remain outstanding. This means equity can be repaid before senior debt.

2)     Covenant-lite 1.0 issued pre-crisis was largely limited to larger better quality “BB” type firms. The post crisis covenant-lite 2.0, now the majority of the market, extending the practice to lower quality firms. Thus, the 2.0 credit performance will likely decline relative to 1.0. Sounds like the problem with extrapolating prime mortgage performance prior to the subprime mortgage meltdown.

3)     The limited 15+ year history of covenant-lite is perhaps too short to draw meaningful conclusions. It may not include peso risk - the “earthquake” event that is not yet reflected in the sample period. We saw this same type of error in the pre-crisis structured finance market.

Investors beware?

J