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Capital Markets

Turnaround in Covenant Credit Quality

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September 09, 2019

By John Hintze

The steady decline of covenant credit quality in leveraged loans appears to be reversing, at least on the margins, as investors anticipate lower rates and borrowers favor high-yield bonds over loans.

A recent report by Moody’s Investors Service notes that the rating agency’s Loan Covenant Quality Indicator (LCQI), in which 1.0 denotes the strongest covenants and 5.0 the weakest, fell 11 basis points in the first quarter to 3.92, the lowest score since third quarter 2016. The indicator fell 10 points in fourth quarter 2018, down from its highest-ever score of 4.13 in the previous quarter.

Not letting up. The trend appears to be continuing, according to Derek Gluckman, vice president and senior covenant officer at Moody’s. He said that the aggressiveness in covenant terms that peaked last year has continued to lessen this year, and there may be “pushback” by investors between when term sheets are issued and the deal is finalized.

“There’s an increased level of anxiety among investors, and particularly that there may be consequences as a result of weakening covenant protections,” Mr. Gluckman said.

He added that it is difficult to quantify the extent to which that anxiety has impacted covenants, given that market supply and demand has quite clearly been shown to be the driving factor shaping covenants.

“The dropping LCQI score is less a reflection of materially enhanced investor protection than an indication that something different is happening in the market—the shift in investors’ preference for bonds rather than loans.” —Derek Gluckman

The corporate-borrower angle. Weaker covenants give borrowers more flexibility, and the covenant that regularly kept corporate treasury executives on their toes—financial maintenance—has been left out of virtually all loan deals for years. The recent strengthening has focused around incurrence covenants that are tested for a specific event, such as when a borrower wants to incur more debt. Nevertheless, the LCQI score indicates that loan covenants are still very weak. Mr. Gluckman said the average score for loans in 2007, before the financial crisis, was closer to 2.5.

“In the longer arc of history, loans are still extremely weak in terms of the covenant protection,” he said. “Our expectation is that we’re not going to see a wholesale change in the [covenant] documentation until there is a wholesale change in the market—a change in the dynamics for loan demand.”

Not a deterrent for loans. Mr. Gluckman added that the recent covenant strengthening is highly unlikely to deter any borrowers from coming to market in the foreseeable future. But it is another indication of where liquidity is shifting in terms of corporate debt.

“The dropping LCQI score is less a reflection of materially enhanced investor protection than an indication that something different is happening in the market—the shift in investors’ preference for bonds rather than loans,” Mr. Gluckman said.

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