Cov-Lite – Yield hunting shifts power from lenders to borrowers

on Jun 26, 2013 in Fixed Income, Home | 2,518 comments

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In their pursuit of yield, investors appear to have materially increased their appetite for risk by accepting increasingly looser covenant packages.

During the last credit bubble, we saw a large increase in cov-lite loans and this phenomenon is now reemerging again. The question is, what if cov-lite features are given to less worthy borrowers?

I personally have some reserves for cov-lite loans being extended to companies in dubious financial health, which could be adversely affected by higher interest rates.

As far as literacy is concerned, a single borrower, rather than borrowing from a single bank, would borrow from a consortium of banks, also known as syndicated loan. Since no borrowers can maintain relationship with dozens of different banks at the same time, covenants – promises the borrower would make to its lenders – replaced the trust relationship previously established between a borrower and its prevailing bank. Essentially, loans were becoming more like bonds: they were becoming debt instruments to be traded between various investors, rather than loans which a single bank would hold to maturity and beyond.

Coming back to our topic, cov-lite loans are more appealing to issuers because they entail less-restrictive covenants that enable lenders to take action if a company’s financial ratios breach specific limits. If any of those ratios were violated, that would count as an event of default on the loan, and the borrower would be forced to renegotiate with the consortium.

A recent Moody’s report says, “a cov-lite capital structure allows for increased financial flexibility at a time when a company needs it most, potentially allowing it to forestall default while getting through a choppy patch in its business”. But does that flexibility only serve to increase the severity of default further down the road? If banks can’t interfere early, does that mean they are going to end up taking bigger losses later?

As Moody’s puts it, there’s an assumption “that cov-lite issuers are less likely to default, but once they do, value may have deteriorated to a greater degree than it would have if lenders had been able to step in earlier to address a breached covenant”. Is the recent surge in cov-lite a source of concern for investors?