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Yet Another Record for US Covenant-Lite Loan Issuance

The share of outstanding leveraged loans that are covenant-lite crept to another record high in February, reaching 75.8%, according to LCD and the S&P/LSTA Loan Index.

At the end of February the amount of U.S. leveraged loans outstanding was $984 billion, meaning there is now $745 billion of covenant-lite loan debt held by institutional investors.

The share of outstanding cov-lite loans matches the rate that newly-issued loans are cov-lite, according to LCD. Of the nearly $92 billion of U.S. leveraged term debt issued so far this year, $69 billion is cov-lite, according to LCD.

Cov-lite deals in some ways are structured akin to high yield bonds. They feature incurrence covenants, meaning an issuer must meet financial tests only if it wants to take particular actions (pay a dividend to its private equity owner, for instance). Fully covenanted loans, on the other hand, are far more restrictive. They entail maintenance covenants, where an issuer must meet financial tests each quarter, whether or not it wants to undertake an action.

Historically, cov-lite loans have defaulted at about the same rate – or slightly less often – than traditionally covenanted loans, though at the end of the last credit cycle – coinciding with the financial crisis of 2007-08 – there was a fraction of the cov-lite loan amount outstandings that there is today.

You can read more about how cov-lite loans work in LCD’s Loan Market Primer (it’s free).

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Riskier Leveraged Loan Issuers Load up on Cov-Lite Deals

Covenant-lite loans – the borrower-friendly debt instrument that some worry will hinder recoveries once the long-running bull-market credit cycle turns – have dominated the U.S. leveraged loan segment for several years now.

But as institutional investor appetite for higher-yielding assets continued hot throughout 2017, increasingly the cov-lite universe has become comprised of lower-rated, riskier, single-B credits.

Indeed, by the end of 2017 there was roughly $390 billion of single-B cov-lite loans outstanding, according to LCD. That’s far and away a record, and up dramatically from the $320 billion at year-end 2016 (the total had grown to $396 billion as of last week, by the way).

Just how strong has appetite been for these riskier deals, even without the investor protection that fully-covenanted loans offer?

single-B cov-lite by rating

Single-B credits accounted for 72% of U.S. cov-lite issuance last year –or $272 billion – the highest share since 2012, when these deals took up 82% of the cov-lite segment. In 2012, however, this sample totaled a paltry $52 billion, as the U.S. leveraged loan market was still proceeding cautiously after the financial crisis, a few years previous.

Cov-lite activity in the single-B segment has continued into 2018. While issuance in that ratings category had dipped to 58% of all cov-lite deals so far this year, it was as high as 82% a few weeks ago, according to LCD.

Cov-lite loans less restrictive for a debt issuers, compared to traditionally leveraged loans. Their popularity has surged over the past few years, particularly as retail investors poured money into the loan asset class in anticipation of higher interest rates. – Tim Cross

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Leveraged Loans: Another Record for US Covenant-Lite Market Share

cov-lite US share

Covenant-lite loans, an issuer-friendly feature that offers less protection for lenders and investors than traditionally structured credits, now account for a record 75% of outstanding U.S leveraged loans, according to LCD.

January is the 10th straight record month for cov-lite market share, as those credits remain the norm in a lending segment that has just completed a year of unprecedented issuance. As recently as 2015 the cov-lite share of the market was roughly 60%.

Cov-lite deals in some ways are structured akin to high yield bonds. They feature incurrence covenants, meaning an issuer must meet financial tests only if it wants to take particular actions (pay a dividend to its private equity owner, for instance). Fully covenanted loans, on the other hand, are far more restrictive. They entail maintenance covenants, where an issuer must meet financial tests each quarter, whether or not it wants to undertake an action.

Cov-lite loans are not without their detractors, of course. Market bears say the massive amount of cov-lite debt now outstanding will impact recoveries on leveraged loans when the current credit cycle – now approaching its tenth year – turns.

Historically, cov-lite loans have defaulted at about the same rate – or slightly less often – than traditionally covenanted loans, though at the end of the last credit cycle – coinciding with the financial crisis of 2007-08 – there was a fraction of the cov-lite loan amount outstandings that there is today.

About the overall record U.S. leveraged loan issuance in 2017: There was $502 billion of higher-yielding institutional issuance last year, along with $146 billion or pro rata credits (revolving debt and amortizing term loans, usually bought by banks, as opposed to other investors), for a total of $649 billion, according to LCD. – Tim Cross

You can read more about how cov-lite loans work in LCD’s Loan Market Primer (it’s free).

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Distressed Debt Outlook: Lack of Leveraged Loan Covenants May Lengthen the Default Process

With more than $2.5 trillion outstanding in the U.S. high-yield bond and leveraged loan markets—twice that of pre-crisis volumes—and leverage at lofty levels, the opportunity set for investors specializing in buying up the debt of troubled companies could be significant. In time.

In this long bull market, default rates have remained stubbornly low, with the pool of debt trading in distress at nearly 80% less than the February 2016 peak. Right now, there just aren’t as many companies in distress as there used to be.

“Pickings for distressed investors are very slim right now, but that can change on a dime,” says Jeff Hammer, co-head of Houlihan Lokey’s illiquid financial assets practice, adding that this market has always proven to be one where you need to move quickly, and in size, in order to make the kind of returns that can carry you through to the next cycle.

Covenant erosion

Covenant erosion has been an ever-present concern for investors on both sides of the Atlantic over the last few years, and while a lack of investor protections is deemed unlikely to increase the overall default volume, it may lengthen the default process if there is no covenant-related event to force struggling borrowers to the bargaining table with their lenders. Such a delayed default could potentially worsen recoveries.

Among defaulted credits within the loan market, 81% of issuers in the S&P/LSTA Index in 2017 were covenant-lite. This compares to 55% in 2016 and to just 14.3% during the 2009 default peak. — Rachelle Kakouris

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European Leveraged Loan Default Rate Drops to Record Low

european leveraged loan default rate

In November, for the fifth month running, there were no defaults among loans in the S&P European Leveraged Loan Index (ELLI). As a result, the European leveraged loan default rate dipped to 1.16%, its lowest point since LCD began tracking this data in 2008, from 1.41% the previous month.

In the 12 months ended Nov. 30 the ELLI tracked €1.3 billion of institutional loan defaults and restructurings, down from €2.3 billion tracked at the end of 2016.

The ELLI default rate is calculated by summing up the par amount outstanding for issuers represented within the index that have defaulted in the last 12 months, and dividing that by the total amount outstanding in the index at the beginning of the 12-month period (excluding issuers that have already defaulted prior to this date).

For the purposes of this analysis, LCD defines “default” as (a) an event of default, such as a D public rating, a D credit estimate, a missed interest or principal payment, or a bankruptcy filing; or (b) the beginning stages of formal restructuring, such as the start of negotiations between the company and lenders, hiring of financial advisors, etc.

An historical low for loan defaults comes at an interesting time for the asset class. First off, the current bull-market credit cycle is chugging along in its ninth year, leading more than a few to speculate that defaults are bound to kick and (and soon).

Also, as credit market bears are fond of pointing out, part of the reason defaults remain low is that more and more issuers now take advantage of ‘covenant-lite’ loan structures, which place fewer restrictions on the borrower. Because of the cov-lite loans, issuers have much more room to maneuver in the face of financial obstacles, often putting off default proper (for a while, anyway, bears will add). – Staff reports

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Covenant-Lite Issuance Booms in European Leveraged Loan Market

The supply/demand imbalance that has characterized the leveraged loan market on both sides of the Atlantic for the bulk of 2017 has continued to allow arrangers to structure deals in an increasingly borrower-friendly way — the most glaring of these developments being the absence of maintenance covenants in loan documentation.

By the end of the third quarter, covenant-lite deals comprised 74% of issuance syndicated in Europe in the year to date, roughly the same as in the U.S. This compares with 60% for the full-year 2016, and 57% for the comparable year-over-year period. The percentage of covenant-lite deals has risen consistently since 2012, when such transactions comprised only 9% of full-year issuance.

Though now standard, cov-lite is not without its detractors, as these loans – which feature covenant protections more similar to high-yield bonds than to traditional leveraged loans – allow a borrower more flexibility before a potential default.

“[With cov-lite] there are no more early warning signals,” says a lawyer active in the syndicated loan market. “The first time you can actually do something as a lender is at payment default.” – Staff reports

You can read more about cov-lite loans in LCD’s Loan Primer. 

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Leveraged Loans: Covenant-Lite Share of Market Inches to New High

US cov-lite share

With investors continuing to clamor for higher-yielding assets, issuance of riskier ‘covenant-lite’ credits in the U.S. leveraged loan market inched to another record high 2017’s third quarter, according to LCD.

Covenant-lite loans place fewer restrictions on a borrower, making them especially popular with issuers, and prominent when there is pronounced institutional investor demand.

They are  structured more like a high-yield (or ‘junk’) bond, as they have financial incurrence covenants – these require lender approval only if the borrower wants to take an action, like adding more debt – as opposed to more restrictive maintenance covenants – where a borrower has to meet quarterly financial tests.

(You can read more about how cov-lite loans work here.)

As of Sept. 30, 72.9% of the all U.S. leveraged loans outstanding feature a covenant-lite structure, up slightly from the previous month, according to the S&P Leveraged Loan Index. With total loan outstandings now at $947 billion (the most ever), that means there is some $690 billion of outstanding leveraged loan paper that is covenant-lite.

While the outstanding numbers are impressive, the new-issue levels of covenant-lite loans are even more eye-catching. So far in October, for instance, 82% of leveraged loans issued in the U.S. have been covenant-lite, nearly matching the full-month record of 84%, in August.

For reference, there outstanding share of cov-lite loans once year ago was 66%. Three years ago it was 58%. – Tim Cross

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Fridson: High Yield Bond Covenant Quality See Record Plunge in August

The covenant quality of high-yield new issues suffered its biggest month-over-month decline ever in August. That plunge brought quality almost to the weakest covenant quality score on record. On a scale of 1 (strongest) to 5 (weakest), the FridsonVision version deteriorated by 0.73 points, to 4.59, from July’s 3.86 (see chart below). The worst score ever recorded was just a hairsbreadth worse, at 4.61 (June 2015).

hy cov quality

To provide background, “Covenant quality decline reexamined” (LCD News, Oct. 1, 2013) describes how we modify the Moody’s CQ Index to remove noise arising from month-to-month changes in the calendar’s ratings mix. On average, covenants are stronger on triple-Cs than on single-Bs, and stronger on single-Bs than on double-Bs. Therefore, for example, if issuance shifts downward in ratings mix in a given month, without covenant quality changing within any of the rating categories, the Moody’s CQ Index will show a spurious improvement. We eliminate such false signals by holding the ratings mix constant at an average calculated over a historical observation period.

In August, Moody’s version of the index worsened by 0.49 points, to 4.54, from July’s 4.05. The rating agency’s slightly more upbeat score (4.54 versus FridsonVision’s 4.59) reflected the distorting impact of a below-average concentration of issuance in the Ba category in August (24.0% versus historical mean of 32.4%). That effect was partially offset by a below-average concentration in Caa issues (20.0% versus a historical mean of 18.6%).

August’s precipitous month-over-month drop in covenant quality resulted from an across-the-board worsening in each rating category. By rating, the July and August average scores were as follows:

In short, issuers took full advantage of the shift in market conditions in their favor, as evidenced by a pickup in primary activity, from just 13 issues in July to 25 in August.

An across-the-board deterioration similar to last month’s contributed to the all-time record one-month plunge in the Moody’s version of the covenant quality index—0.76 percentage points in May 2016. That number was exaggerated by a large month-over-month increase in Ba concentration. Filtering out that effect, the FridsonVision series showed a deterioration of 0.68 points in May 2016, somewhat short of the record of 0.73 points posted in August 2017.

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Covenant-Lite Share of US Leveraged Loan Market Hits (Another) Record High

covenant-lite loans

Note: This story and chart have been updated to include July-end numbers. 

Covenant-lite loans, which offer less protection to institutional investors than do traditionally structured credits, continue to make up more and more of the $943 billion U.S. leveraged loan market. At the end of July, 72.7% of all outstanding loans were cov-lite, according to LCD. That’s the most ever, and is up from roughly 69% at year-end.

Cov-lite loans are credits that have  incurrence covenants – similar to a junk bond – rather than more restrictive maintenance covenants (you can read much more about this in LCD’s Loan Primer). For obvious reasons, they are more attractive to issuers, and have gained steady acceptance from loan arrangers and investors, particularly since 2012, when the U.S leveraged loan market found a higher gear after the financial crisis of 2007-08.

While the popularity of cov-lite loans has prompted worries in some corners of the market, historically, these deals have not defaulted any more frequently than loans with traditional covenants. Then again, as naysayers are fond of pointing out, they’ve never comprised this much of the market before, so they will be under scrutiny once the current credit cycle turns. – Staff reports

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Leveraged Loans: Covenant-Lite Structure Gains Ground in Middle Market

middle market cov-lite loans

Covenant-lite structures, long common among larger loans that are broadly syndicated to institutional investors, are increasingly finding their way into smaller transactions.

An imbalance between supply and demand leveraged loan paper, stoked by fundraising for higher-yielding middle market credits, is behind the expansion of borrower-friendly features.

So far in 2017, the share of covenant-lite deals with debt totaling less than $250 million has climbed to 27%, from 11% in 2016. The share this year is roughly on par with that in 2015, LCD data shows.

Among covenant-lite deals now in market is a $200 million loan backing lift-truck manufacturer Hyster-Yale Group. Pricing on the loan, which was initially brought to market at L+425–450, at a 99 original-issue discount, was tightened due to investor demand, to L+400, at 99.75.

Covenant-lite loans are credits that feature bond-like incurrence covenants, as opposed to more restrictive maintenance covenants (you can read more about how cov-lite loans work here).

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This story first appeared on www.lcdcomps.com, an offering of S&P Global Market Intelligence. LCD’s subscription site offers complete news, analysis and data covering the global leveraged loan and high yield bond markets. You can learn more about LCD here.