Back in March, we presented a LeveragedLoan analysis according to which the amount of covenant-lite loans had just hit an all time high. Since then, as a result of rising rates and unprecedented CLO demand, the loan market has continued to grow, and having recently surpassed the $1 trillion mark, is on pace to catch up with the size of the entire junk bond market.
Meanwhile, it is no secret that Covenant-lite has all but defined the $1 trillion U.S. leveraged loan market lately, as increasing numbers of speculative-grade corporate borrowers take advantage of this debt structure, amid sustained investor appetite in the asset class resulting, allowing debtors to issue loans on any terms they want.
In fact, issuance of cov-lite loans – which are less restrictive for a borrower, and thereby offer lenders less protection than do traditionally covenanted credits – just hit 77% of all outstanding loans.
The rapid growth of cov-lite has raised eyebrows, to say the least, as the current borrower-friendly credit cycle enters its tenth year (that’s a long time between spikes in defaults).
Confirming this troubling trend, today none other than rating agency Moody reported that its Loan Covenant Quality Indicator (LCQI) dropped to its record-worst level in the first quarter of 2018, the rating agency says in a new report. The LCQI weakened by 12 basis points to 4.12 from 4.00 in Q4 of 2017.
"While the rate of deterioration in covenant quality has slowed, protections remain distressingly weak on average," said Derek Gluckman, Moody's VP-Senior Covenant Officer. "Investors should remain wary given the risks presented by most loan documents and the likelihood that any steadying of covenant protections is temporary."
Gluckman added that collateral remains a key concern for investors, and warns that the loosening of covenant protections raises the risk that the collateral securing loans will be unavailable to support recoveries in a bankruptcy scenario.
But it’s not just the sheer volume of cov-lite outstandings that matters. LCD recently looked at the debt cushion of outstanding loans – the amount of debt in a borrower’s capital structure that is subordinated to the senior loan – and found that, increasingly, today’s cov-lite deals have little or no debt cushion beneath them. This is important because the lack of a debt cushion significantly lessens what an investor will recover on a loan, if that credit defaults.
How much has this debt cushion eroded?
As of May 31, 23% of all cov-lite loans did not have any debt, such as a mezzanine tranche, high yield bond, or other, below the cov-lite facility. That’s an all-time high, and is up from 18% five years ago, and from just 10% at the end of 2007 (shortly before the financial crisis), according to LCD.
The punchline: this means that cov-lite loan outstandings are not only at record levels, but a greater portion of these transactions do not have any debt cushion to absorb losses in case of a default.
In other words, during the next default cycle, whenever the business cycle finally turns, loan investors not only will have virtually no "secured" protection, but are now the de facto equity tranche in numerous deals, or said otherwise, for the first time in history, loan investors are looking at 0 recoveries in default.