Loans with fewer protections are a warning sign

Last updated: October 18, 2013 5:17 pm

Loans with fewer protections are a warning sign

By Tracy Alloway in New York

The growth of ‘cov-lite’ may point to overheating in credit

The government shutdown temporarily hit markets from stocks to bonds to the $4.5tn “repo market” that underpins the US financial system. But one asset class was curiously immune to the two-week gridlock in Washington – leveraged loans.Five years of the Federal Reserve’s ultra-low interest rates have made the market for loans to highly indebted companies white-hot in recent years, as investors clamour for the higher yielding assets and corporates rush to refinance old debt. Some $499bn worth of the loans have been sold so far this year – almost eclipsing the record $535bn issued in 2007, just before the bursting of the credit bubble.

Ironically, the economic turmoil wrought by polarised politicians could give the leveraged loan market another fillip in the form of interest rates that will probably be lower for longer. The Fed is unlikely to raise rates in the face of economic weakness and fiscal drag.

So far the leveraged loan market has weathered every stumbling block thrown at it this year – from this month’s political impasse to the “taper tantrum” that shook up most other debt markets in June. At the same time, a whole host of loan structures last seen in the years before the financial crisis have crept back into the credit market. Loans that come without some of the traditional protections for lenders – known as covenants – have become the norm rather than the exception in the market.

More than $200bn of “cov-lite” loans have been issued so far this year, far eclipsing the $100bn sold in 2007, according to data from S&P Capital IQ. The record issuance means that about 56 per cent of new leveraged loans are now cov-lite. The merits of such loans have been hotly debated.

Intuitively, such loans appear to swing the balance of power to corporate borrowers at the expense of lenders. Lenders have often argued that covenants act as an early warning sign to problems further down the road. With cov-lite, the worry is that the first time a borrower sits down with its lenders is after it’s already defaulted.

At the same time, defenders of cov-lite loans point to a host of facts and figures that seemingly make the case for loans with fewer lender protections. The default rate for cov-lite loans between 2007 and 2010 was 8.7 per cent, according to S&P, far lower than the 14.6 per cent rate for normal loans. Recovery rates for cov-lite stand at 89.6 per cent versus 81.5 per cent for non-cov lite.

Cov-lite, proponents say, gives companies financial flexibility. When the credit cycle turns, companies with cov-lite commitments can concentrate on survival rather than placating their creditors and covenants. They also point out that cov-lite loans have been given traditionally to more robust companies – a fact that might go some way towards explaining lower default rates for cov-lite.

I wonder, however, whether the advent of cov-lite as the new normal in the loan market turns that theory on its head. Once the vast majority of leveraged loans are issued as cov-lite, few will be able to argue that only the strongest credits are getting the cov-lite treatment. The trend has not gone unnoticed by regulators.

The Office of the Comptroller of the Currency, which is charged with supervising US banks and other credit institutions, criticised a staggering 42 per cent of the nation’s leveraged loan portfolio in its last review of credits. “Banks should ensure they do not unnecessarily heighten risk by originating poorly underwritten and low- quality loans,” the OCC warned. “Poorly underwritten or low-quality leveraged loans, including those that are pooled with other loans or participated with other institutions, may generate risks for the financial system.”

It’s doubtful that such loans pose systemic risk in the same way that larger parts of the financial market do. We’ve seen in previous financial crises that the breaking point tends to come when supposedly risk-free assets, such as AAA-rated mortgage-backed securities or government bonds, begin to deteriorate.

But much like covenants themselves are supposed to provide early notice of impending trouble for loan investors, the increasing lack of traditional lender protections could well act as a warning sign that overheating has crept back into credit markets. With interest rates likely to be lower for longer thanks to stubborn politicians, that warning sign could well end up flashing even more brightly.