Corporate creditors should take note that the covenant-lite loans that are predominating in the North American leveraged loans sector provide new risks that could jeopardize lenders’ ability to repay.
Cov-lite loans accounted for approximately 77% of the leveraged loans that Moody’s Investors Service has analyzed since the beginning of 2016; this figure is up from 25% a decade ago. Vanishing maintenance covenants and those covenants providing leveraging, lien and structural protections may not prohibit borrowers from taking certain actions that could harm their ability to pay the loans back, Moody’s said.
"Strikingly, the covenant packages are weakest in lower-rated cov-lite loans," said Derek Gluckman, a Moody's vice president and senior covenant officer. “Cov-lite's domination of the leveraged loan market is now well established. But cov-lite loans are more risky for investors, with the absence of maintenance covenants depriving them of early warnings of distress, periodic oversight and the opportunity to secure a place at the head of the line when enforcing their rights."
Libor spreads are also tightening on these cov-lite loans, the analysts warn. “The expectation of receiving some premium for taking on increased risk remains challenged by extraordinary demand in the loan market,” Moody’s analysts said. “Analysts at the rating agency have observed a compounding of default and structural risks in the lower-rated cov-lite loan space where the weakest covenant packages are found, but noted offsetting compensation is not so clearly evidenced when looking at spreads.”
Meanwhile, in a separate report, Moody’s analysts note that high-yield bond issuance increased to its highest monthly level this year, while overall leveraged finance volumes have reached a post-crisis high.
High-yield bond volumes reached $21.7 billion in October, up from $5.7 billion in September as well as the prior October’s $4.3 billion, Moody’s said. "While larger transactions contributed to the exceptionally large high-yield bond issuance, October's volumes also benefited from the high number of issuers, including first-time issuers, accessing the market. Increased activity in the cable and telecom sectors also boosted loan volumes," said Peter Firth, an associate managing director at Moody's.
Leveraged finance activity so far this year has nearly reached the post-crisis record of $240 billion in 2014.
– Nicholas Stern, managing editor