This week's chart shows the rapid growth in covenant-lite syndicated leverage loans as a percentage of new loan volume. The 66% reached in 2014 well exceeds the pre-crisis 2007 peak of 25%. This has received a great deal of media attention as evidence that a bubble is forming in the leveraged loan marketplace or as a leading indicator of future default levels.
"Covenant lite" refers to loans that do not have maintenance (as opposed to incurrence) covenants. The most common maintenance covenants are leverage tests, such as a maximum leverage level or minimum coverage levels. Covenants provide lenders a remedy if a covenant is breached, the most powerful being an acceleration and repayment of the loan. However, lenders will typically sit down with management and restructure the loan, extracting better pricing and other terms in exchange for a relaxation of covenants.
Covenants don't help pay debt, and they don't improve credit quality. However, they do ensure lenders know about problems quickly, improving the position of a lender in order to enhance ultimate recovery. Covenants therefore serve as red flags for individual loans. The lack of covenants simply means the lender loses some measure of control and forgoes an ability to extract better terms. It's an opportunity cost that can result in a less profitable loan.
However, from a market perspective, the total amount of covenant lite loans in aggregate is not a commentary of the quality of underwriting standards, nor does it provide a good signal about future default rates. Rather, it is a statement of the relative bargaining position of borrowers and lenders. If we are looking for market indicators that signal an impending turn in the credit cycle, we would be better served at looking at the percentage of CCC rated issuers, the percentage of holding company/payment in kind dividend deals, new issuance proceeds used for leveraged buy outs, aggregate maturity levels over the next 2-3 years, and overall leverage statistics.
According to data compiled by JP Morgan, which included the 2008-9 period, there are no material differences in default rate or recoveries between covenant lite and loans with covenants. Ultimately, what matters is underwriting quality. A good example is the currently stressed energy sector. It's not the lack of covenants in their asset-backed lines that will cause defaults to spike; it's the leveraged capital structures in place that were built with $65 plus oil prices in mind.
Key Takeaway: I view the covenant lite issue as a red herring for determining market froth or predicting a turn in the credit default cycle. While it does provide a data point on the current stage of the credit cycle, it doesn't imply causation - in other words, the high percentage of cov light loans does not necessarily signal nor will it cause defaults to accelerate.
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