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.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results. All information referenced in preparation of this material has been obtained from sources believed to be reliable, but accuracy and completeness are not guaranteed. There is no representation or warranty as to the accuracy of the information and Penn Mutual Asset Management shall have no liability for decisions based upon such information.
High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.
All trademarks are the property of their respective owners. This material may not be reproduced in whole or in part in any form, or referred to in any other publication, without express written permission.