Search and Recovery (Third of a series)

Continuing with our special series on leveraged loan recoveries, let’s turn to one of the most pondered questions on the subject; namely, how will covenant-lite loans fare in the next downturn?

At a recent loan market conference, senior S&P analyst Ruth Yang reviewed the lite environment. She reminded attendees that broadly syndicated leveraged loans without maintenance covenants are the “new kids on the block” when it comes to documentation risk. Most of the growth in cov-lite volume (Chart 1) has been post-credit crisis.Today the vast majority of liquid loans are cov-lite. Defaults overall have been relatively scarce during this nine-year economic recovery. Cov-lite defaults even scarcer (see Chart of the Week). While cov-lite was applied to only the best credits in the early stage of the post-crisis period, it appears that qualification has slipped.

In the broadly syndicated market, the share of loan-only deals has grown since 2012 (Chart 2). Without bonds underneath them, loan holders are at risk for lower recoveries. Not surprisingly, then, that the debt cushion below cov-lite loans is also shrinking (Chart 3).

It’s challenging to extrapolate from such limited historic data points on cov-lite defaults to predict what the future will hold in a downturn. Sponsors argue that allowing borrowers maximum freedom from lender interference preserves recovery value. But as all-senior leverage increases, cushions shrink, and terms weaken, will managers regret not having more control when borrower performance slides?