Noninvestment-grade companies looking to borrow, as part of a leveraged buyout or otherwise, are finding an increasingly borrower-friendly market in which loan covenants are minimal and terms ever weaker, and the trend may move even more in their favor.
Moody’s Investors Service said in a recent report that so-called covenant-lite or “cov-lite” loans, which the ratings agency defines as having no ratio-based tests or tests that only spring into action when certain conditions are met, made up 75% of new institutional loan issuance in 2016. It also noted that leveraged loan quality in the first quarter was almost as bad as fourth quarter 2016, when it was at the weakest level Moody’s had ever recorded.
Moody’s says overall covenant protections are uniformly weaker than they were between 2007 and 2011, likely due to heavy investor demand for yield in a low-interest rate, low-default rate environment. Recently, rising interest rates have also lifted demand because of the floating-rate nature of leveraged loans.
“We expect weak covenant protections to continue as long as investor demand for loans remains robust,” Moody’s says in a report titled, “Investor Protection Worsens in April but Narrowly Escapes Weakest Level.”
That’s problematic for institutions investing in syndicated noninvestment-grade debt that they purchase in the primary or secondary loan markets, or get exposure to via private credit funds. However, it’s a boon for corporate borrowers, since the warning signals and subsequent restrictions covenants impose will arrive later, giving those companies more financial flexibility.
In fact, even loans that still retain lots of covenants are structured only “marginally better” than cov-lite debt, Moody’s says.
Fitch Ratings has expressed similar concern in recent reports, adding that beyond covenants the terms of leveraged loans are becoming more favorable to borrowers, and that’s likely to continue in the foreseeable future.
“Borrower-friendly terms that first appeared in the leveraged finance market last year are set to continue, and could deteriorate further if the new administration rolls back restrictive financial regulations,” Fitch said in its recently released “Annual Manual” report.
Fitch notes that anticipated tax reform in particular will affect new issuance, and that the uncertainty around the direction of reform is causing companies to carefully consider their options for financing M&A transactions.
Among the newly prevalent terms that benefit corporate borrowers are shorter most- favored-nation (MFN) sunsets, after which borrowers can add additional debt to the original loan facility that’s provided by the original lenders or new lenders. Fitch says 12-month sunsets have become prevalent and a few transactions have “cleared the market” with six-month sunsets.
Collateral leakage, exemplified by J. Crew in late 2016, is also becoming more common. In that case, the loan terms allow the borrower to transfer collateral – in its case, intellectual property – to a subsidiary that is not a part of the loan agreement, enabling the company to borrow further through the newly collateralized entity without tripping covenants on the existing loan.
In addition, recent loans often do not restrict prepayments of senior unsecured debt, and some don’t limit prepayments of junior lien debt, weakening protections for lenders. They also give borrowers more power in defining EBITDA, which can affect financial covenant ratios and incurrence tests, and enable those companies to increase leverage capacity, Fitch says in a recent report titled “What Investors Want to Know: Weakening Credit Terms.”