“Covenant lite” loan market looks good but borrower credit quality remains the crucial variable.
How much must a borrower pony up to convince his lender to eschew a maintenance test? According to market chatter, about 25 basis points. But Standard & Poor’s Leveraged Commentary and Data recently noted that this is impossible to prove since covenant lite loans are only offered to better credits. This means their spreads are usually inside those of loans to less creditworthy borrowers, even those that have maintenance tests.
This has held true for the past several years, and is even true within a specific rating bucket, indicating that lenders make covenant-pricing distinctions on fairly granular credit data, LCD says. This phenomena is reflected in the returns of loans with and without covenants. In a recent market update, LCD wrote: “Since January 2006 – the first date for which there is a statistically significant sample – covenant-lite S&P/LSTA Index loans outperformed covenant-heavy loans, at 39.28 percent to 36.36 percent. The pattern has held in 2012, with incurrence-test only loans ahead 5.18 percent to 4.86 percent as of May 14.”
The covenant lite loans have performed better because they haven’t defaulted as much as the covenant heavy loans – again, reflecting the fact that banks only extend covenant lite loans to creditworthy borrowers. Loans dating from 2007 – before defaults spiked – in the S&P/LSTA Index reflect this. Only 9.3 percent of covenant lite loans defaulted, compared with 14.7 percent of covenant heavy loans, LCD reports.
This may contribute to banks’ willingness to extend covenant lite loans. In April, fully 40 percent of all loans were covenant lite, the most since November 2007. However, they have only comprised 22 percent of 2012 loans. With the primary loan market slowing, April could come to be seen as a high water mark.