Are Covenants Worth The Paper They Are Written On?

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Rampaging bulls don’t generally like to be shackled and it seems neither do businesses looking to access the best terms on their debt financing.

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At least, that’s how it looks from the current state of the leveraged loan market. That’s because loan covenants are being watered down and carved out at such an alarming rate that it really does beg the question as to whether they still offer sufficient protection to creditors.

‘Covenant-lite’ loans that lack basic protections for investors represent 70% of the market now. This trend is borne out by Street Diligence statistics too, which show a slippage of covenant related features across the board.

In the North America Leveraged Loan Market for the period December 2017 to February 2018, covenant changes, maturity extensions and repricing are all up compared to the previous three months.

More tellingly, the frequency of the existence of financial covenants - such as leverage ratio and covenant ratio - are down, while the existence of leveraged loans with no financial covenants at all has increased from 24% to 33%.

Covenants protect creditors and enable them to wield some influence over how companies operate, including restrictions on further borrowing and maintaining a lender’s position in the capital structure.

With interest rates rising though, so has demand for leveraged loans because of their adjustable rates. While demand remains high and the economy continues in a healthy state, companies will use this situation to negotiate more favourable and less restrictive terms. The worry is that these are high yielding and potentially risky assets, where reducing covenants is a dangerous game.

There are examples like Cortefiel, which used a covenant-lite package to successfully re-organize, that show how limiting covenants can provide the flexibility a company needs to sort out its operations and rebalance the ship.

But what happens when the music stops?

The Toys R Us downfall last year demonstrated how a lack of debt understanding can easily spiral into a situation where no-one knows what’s going on, access to cash dries up and businesses are forced into bankruptcy.

With monetary policy tightening across the world, many investors are predicting that an end to cheap money could cause a downturn. Should this occur, creditors who have allowed businesses to water down loan covenants might be faced with understanding complex debt structures such as Toys R Us, magnified across a whole range of debtors.

Of course, holding risky loans isn’t a problem if the risks are understood. This is why active management by funds with significant loan exposure is crucial. To do this correctly, fund managers need the right information about loan covenants at their fingertips, so they can proactively managing risk rather than react along with the crowd.

It is these active, informed investors who will be able to protect themselves from any storm that the watering down of covenants might bring about.

About The Author

Stephen Hazelton founded Street Diligence in 2012 and has two decades of experience in global financial markets as both an entrepreneur and investor.

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