The share of the $1.06 trillion in outstanding U.S. leveraged loans that is covenant-lite hit yet another record in July, at 77.8%, according to LCD. It is the 15th straight month that cov-lite credits have set an all-time high.
That could well continue.
So far in 2018, 82% of leveraged loans that have been completed in the U.S. syndications market has been cov-lite, amid solid market demand, as institutional investors and retail loan funds continue to sit atop impressive stores of cash. Indeed, assets under management at U.S. loan funds hit a record $176 billion in July, according to Lipper and LCD. That figure has grown from roughly $110 billion in early 2016, when investor interest in the asset class took off amid expectations of long-awaited rate hikes by the Fed (leveraged loans are floating rate, an asset class that tends to fare well in rising rate environments).
Cov-lite loans are in some ways structured akin to high yield bonds, in that they feature incurrence covenants, as opposed to the more restrictive maintenance covenants.
With an incurrence covenant a debt issuer would have to meet a specific financial test only if it wanted to undertake a particular action (like borrow money to fund a dividend to a private equity sponsor, for instance). Under a maintenance covenant the issuer would need to meet regular, specific financial tests, even if it did not want to undertake that dividend deal.
Market pros agree that the cov-lite loan structure will hinder recoveries on bank loans, whenever the current credit cycle turns and defaults begin to mount, though the jury is out as to just how much of a hit recoveries will take.
One hint: S&P’s LossStats, and LCD, conducted analysis on recoveries of cov-lite loans that defaulted before the 2008-09 financial crisis, versus those that were structured and defaulted after the crisis. The later-vintage group of cov-lite loans saw an average discounted recovery of 56%, compared to a 78% average recovery on the earlier deals (though the data in the later sample is thin, as there have been few leveraged loan defaults during this cycle). You can read more about this LossStats analysis here. – Staff reports
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