"Covenant Lite"

Much to the chagrin of debt investors, asset transfers are growing in popularity for distressed borrowers of covenant-lite debt. Senior lenders previously had protections in place that would allow them to assume the core assets of an entity, but incredible demand for yield has caused these protections to deteriorate.

“When a lender is deciding to lend money to a [debt] issuer, they generally are thinking they’re getting credit support from all of the assets of the issuer,” said Anthony Canale, global head of research at Covenant Review, a research firm. “They don’t understand that when you read the fine print, the issuer actually has the ability to move assets.”

An article in the WSJ describes how J. Crew managed to avoid bankruptcy by taking advantage of covenant-lite loan documents:

“J. Crew, and the private-equity firms that control the company, used provisions in its loan documents that govern so-called permitted investments. The company transferred the intellectual property behind its brand name into a newly created affiliate, where the term-loan holders have no claim. The affiliate then issued new debt to its junior bondholders in a swap. The provision is in many other corporate loans and bonds, especially those of companies owned by private-equity firms.”

This maneuver will reduce recoveries on the term loan to 41 cents on the dollar.

An article in Barron’s argues that the final straw pushing the US into recession will be the recovery rates available to creditors. As credit documents became increasingly covenant-lite, the assets available for recovery in the event of default have dwindled.

“Protection-lite loans give lenders weakened contractual protections against borrower actions like reassigning collateral, selling assets, or issuing additional debt. Fewer assets will be available to repay lenders as a result.”

CLOs are most vulnerable because they are the largest buyers of covenant-lite loans, and particularly risky are the loan mutual funds that hold these CLOs. In the event that loan losses increase a liquidity mismatch will cause values to plummet as investors rush to the exit.

An article in the WSJ provided a fantastically concise and simple explanation of the danger cov-lite loans pose for investors:

“The problem with higher leverage is that debt becomes much harder to repay, or refinance, if earnings start to decline. In the past, when debt was too high or earnings didn’t improve, covenants could push companies and lenders to renegotiate terms, which would protect the value of the loan and give the company room to fix its problems. Today, a lack of protection is both encouraging some investors to sell sooner and reducing the price that distressed investors are willing to pay.”