Let the good times roll for non-investment grade corporates in the market for debt financing, at least for now.
Moody’s Investors Service released research earlier this week showing the quality of high-yield bond and leveraged loan covenants continuing to worsen, even as the corporate default rate drops further.
The ratings agency’s Loan Covenant Quality Indicator (LCQI) did improve slightly in first quarter 2017 compared to fourth quarter 2016, falling to 4.01 from 4.06, its weakest level ever. Nevertheless, Moody’s analysts view that 1% improvement as a temporary blip in a long-term trend starting more than five years ago as investor demand for leverage-loans and their premiums outpaces supply.
“The noticeable improvement in the covenant quality of North American leveraged loans in early 2016, stemming from a combination of suppressed demand and market uncertainty, has since reversed,” said Derek Gluckman, vice president at the rating agency, in a July 13 note. “The long-term trend of deteriorating covenant protection has resumed in 2017 on the back of near record-level lending activity this year.”
That’s great news for borrowers, at least for the foreseeable future, as they are obtaining financing with fewer restrictions. In fact, in a market dominated by borrowers’ repricing existing loans, investors’ covenant protections were weaker than they were five years ago in each of the seven risk categories that Moody’s assesses.
The average leveraging risk category score of 4.55 is at the weakest level Moody’s analysts have ever observed, 75 basis points above the long-term average of 3.80, according to Moody’s.
“Such deterioration is most evident in the financial covenants risk category, with protections weakening as covenant-lite (cov-lite) loans grew to represent 75% of the leveraged loan market, against 24% in 2012,” Mr. Gluckman said.
Cov-lite is a euphemism for a deal with no financial covenants, and today it’s arguable that companies who fail to get cov-lite financing just aren’t trying hard enough. However, many of the covenants that do accompany loans today aren’t what they used to be.
Another prevalent trend is that the cushions separating borrowers from noncompliance id growing so much that effectively the loans have become cov-lite. Evan Friedman, a senior vice president at Moody’s, said that traditionally borrowers disclosed their financials and negotiated with lenders acceptable leverage, secured-leverage and other ratios that went into effect on the loan’s closing date. A company’s performance, M&A and other activities were also factored in to generate financial covenant ratios representing the agreed-upon boundaries between which a company could pursue its business without raising significant concerns among lenders.
“If those financial maintenance covenants are eliminated, or so wide that they are effectively eliminated, the company has greater flexibility to run its business without having to monitor compliance with those ratios,” Mr. Friedman said.
Lenders, however, lose critical information. Since borrowers regularly reported their status with respect to those ratios, lenders had early warning about when a borrower was running into trouble, and they may have tweaked the covenants for a fee to give borrowers more flexibility.
“When you remove the covenants, the lenders don’t get the same level of reporting and have no clout to do anything even if they see other signs that the company will be less able to satisfy those ratios,” Mr. Friedman said.
Covenant quality on high-yield bonds has also degraded “drastically,” according to Moody’s. The rating agency said in a July 11 report that its Covenant Quality Index (CQI), a three-month rolling average, plummeted in May to 4.48 from 4.26, just four basis points off its worst score eve of 4.52, in August 2015. June saw the highest concentration of cov-lite high-yield bonds, driving the month’s very weak covenant quality score of 4.68.
“The concentration of Ba-rated bonds continues to increase, while Caa/Ca-rated bonds lose market share…,” the Moody’s report said.
So why aren’t lenders exercising more caution? The search for yield in the ongoing low-interest-rate environment is most likely the primary reason. It also helps that the speculative-grade-company default rate continues to trend downward.
The global trailing 12-month speculative-grade default rate closed at 3.2% in the second quarter of 2017, down from 3.9% the prior quarter and 4.7% a year ago, Moody’s noted in its latest global monthly default report.
“A lot of investors aren’t squeaking very much because they see where the default rate is, and so they’re playing a game of chicken,” Mr. Friedman said. He added that some are taking their chances with cov-lite loans and betting they’ll know when to sell those assets. And that dynamic is unlikely to change until a major macro event prompts investors to look for safer investments. Indeed, borrowers and their attorneys are looking for ever more creative ways to further weaken covenants, and they are still finding eager lenders.
“It’s an issuer’s world right now as far as covenants go, both for in the leveraged loans and high-yield bond space,” Mr. Friedman said, adding, “And the pricing their getting is pretty good, too.”