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Another sign of credit froth: cov-lite volume higher than in 2007 [ClearOnMoney]
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Another sign of credit froth: cov-lite volume higher than in 2007

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Commentary

Another sign of credit froth: cov-lite volume higher than in 2007

27 May 2013 by Jim Fickett.

Normally when loans are made to companies considered a poor risk, part of the loan contract is a set of “covenants” that allow lenders to intervene if the borrower's ability to repay deteriorates. One of the clear signs of trouble brewing in 2007 was the emergence of “cov-lite” loans with the usual covenants weakened or missing altogether. This is happening again now. From the Financial Times:

The proportion of so-called “cov-lite” loans has soared to more than 50 per cent of all leveraged loan issuance so far this year, twice the level seen during the credit boom in 2007. …

Some strategists argue that cov-lite lending could be a “new normal”, the wisdom of which will be tested in the next economic downturn. Moody’s, the credit rating agency, last week said it saw signs of a “covenant bubble” that poses dangers for loan investors when the US Federal Reserve begins to tighten monetary policy.

Covenants typically set parameters that force a company to stay within a particular debt-to-earnings ratio, or keep earnings above a certain multiple of interest payments. If covenants are breached, creditors can insist on a financial restructuring, even if the company is not close to bankruptcy.

Record inflows this year into funds which buy loans, plus demand from leveraged investment vehicles called collateralised loan obligations, have sent loan prices sharply higher and shifted negotiating power to the issuers of loans. …

So far this year, $129bn of leveraged loans have been sold with cov-lite features, up from $22bn in the same period last year, according to S&P Capital IQ data. Issuance was $96bn for the whole of 2007.

Immucor, a blood transfusions technology company acquired by TPG in 2011, and Regal Cinemas are among companies which have swapped loans with covenants for new cov-lite loans this year – a practice called “covenant stripping” – according to S&P Capital IQ.

The fact that cov-lite loans are rising so rapidly suggests to me that we are now in the late stages of this credit cycle.