NEW YORK, Feb 17 (Reuters) - Investors’ appetite for leveraged loans is allowing companies to line up debt with few safeguards on an unprecedented scale.
Too much demand for too few high-yielding loans has allowed issuers to pile up debt without covenants that would protect recoveries in the event of a downturn.
The amount of loans without covenants in the US has already reached more than US$90bn this year. That puts it on track to surpass the US$128bn quarterly record, set in the fourth quarter of 2016.
“It’s incredibly issuer-friendly out there right now,” said a senior banker. “You aren’t seeing much investor pushback on any deals whether it’s on terms or price.”
The vast majority of this record volume stems from the recent surge in repricing and refinancing activity. This week food-service distributor US Foods repriced a US$2.2bn term loan without covenants. Telecommunications firm Level 3 upsized a covenant-lite loan to US$4.6bn from US$2.6bn this week, as well.
Analysts say that while covenant-lite loans are not necessarily problematic while default rates are low, the lack of covenants could end up hurting investors in the event of a sharp downturn.
Without covenants regularly testing specific financial measures, investors do not have as much day-to-day clarity into the finances of the companies they are lending to. This creates the potential for companies to lose more equity in the event of default caused by something such as an unanticipated missed interest payment than if a company had been forced into default earlier due to violating a covenant.
“The fear is that someday when we test these structures, they could ultimately impact recoveries,” said Enam Hoque, a vice-president at Moody’s. “If the covenant-lite structure hasn’t been tested yet to the extreme, there’s certainly a possibility that the next down cycle could see those recoveries go down.”
Cov-lite deals have been around for years, but there has yet to be an extended default cycle while this kind of loan has been in vogue. The last default cycle, which began in 2008, lasted for just 21 months, according to Moody’s, which wasn’t long enough to truly test how such loans would fare in an extended default period such as the one that started in 1999 and lasted 57 months.
Leveraged loans have become increasingly favored among investors as demand has heated up for floating-rate assets due to the promise of rising interest rates. Leveraged loan funds saw 14 consecutive weeks of inflows up to February 15, with the four-week moving average standing at US$936.7m.
This has led to more relaxed lending terms. So far this year price cuts occurring during the marketing process of a loan have outnumbered price hikes by a ratio of 18-to-1. Leverage for buyouts has climbed to 6.5 times, the highest level since 2014 when cov-lite issuance hit its previous peak.
Leveraged loans are being closely watched by regulators – with a particular eye on leverage levels — but they may also require changes to underwriting, which could include covenant language. Regulators have said loans without strong covenants should have other safeguards to protect credit quality.
“Weak covenant protections are definitely something that regulators have flagged in the past, but I don’t know if it’s something they’ll continue to scrutinize,” Hoque said. “While they have drawn a line in the sand at six times for leverage, they have been more vague when it comes to specific covenant terms.” (Reporting by Jonathan Schwarzberg; Editing By Matthew Davies and Michelle Sierra)
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