Putting cov-liter fuel on the flames

Tom Traill - 10 May 2018

The tower of US corporate borrowing has grown taller and shakier than ever (figure 1). The credit offer has assumed extremely generous proportions since the financial crisis and that offer has been accepted to an increased extent. The level of new borrowing is 50 per cent higher than in 2007 in nominal terms, and the typical quality of new debt issuance has fallen appreciably. The massive growth of covenant-light (cov-lite) loans and the increased take-up of credit from issuers with the weakest investment grade ratings has raised the stakes appreciably.

A cov-lite loan is one that has fewer maintenance covenants in place for its duration. These are stipulations, usually tested quarterly, that prevent the borrower from pursuing certain activities, for example further borrowing, incurrence of liens or restricted payments. These also act as warning signals if the borrower is in distress. The lack of warning lights means that, should a borrower get into trouble, there may be little or no opportunity for the lender to reprice its loans. A debt can go from apparently healthy to fatally impaired in weeks, in the absence of the early warning system that the covenants are designed to provide.

A recent paper from Standard and Poor’s argues that cov-lite loans have taken off thanks to the combination of historically low interest and default rates and growing investor demand (figure 2). Three-quarters of new institutional loans were cov-lite in 2017, but perhaps more notable was that cov-lite loans accounted for 85 per cent of B-rated issuance. It isn’t the strongest borrowers that are receiving slacker oversight, it’s the weakest!

The S&P report says that for firms that went bankrupt between 2014 and 2017 – a period of very low interest rates and steady economic momentum – those with cov-lite loans had an average recovery rate of 72 per cent compared to 82 per cent for those with more covenants. In the fourth quarter of 2017 these rates had fallen to 75 per cent for non cov-lite and just 66 per cent for cov-lite, indicative of further deterioration.

Cov-lite loans are one of the better-known aspects of falling lending standards, but by no means the only one. The proportion of European speculative grade corporate issuers ranked ‘B’, ‘B-’, or ‘CCC/C’ was around 16 per cent in 2002 and reached the lofty heights of the low 30s in 2006. It is now 50 per cent. Other schemes, such as aggressive EBITDA add-backs, and more generous or flexible baskets for permitted debt or restricted payments, also erode the quality of the debt and make it all the more important for investors to grasp the finer details of the deal.    

The rising interest environment and the ongoing trend of looser lending to weaker borrowers means that there is every reason to be wary of the corporate borrowing space. Although cov-lite loans existed during the financial crisis, they were not so prevalent or available to issuers of such poor quality, and the current cohort of corporate debts has not been tested in particularly choppy waters. Yet.

Figure 1

Data source: US Federal Reserve and St Louis Federal Reserve

Figure 2

Source: Standard and Poor’s

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