Leveraged loans are way past “cov-lite”

The loan market for highly indebted companies has had a lot to celebrate this year.

In May, the so-called leveraged loan market, which is typically tied to the three-month Libor rate (plus a spread relative to the respective risk), and therefore does well in rising rate environments, surpassed the $1tn mark in the US.

Issuance, according to S&P Global Market Intelligence's LCD unit, is now on course to top last year's record high of $650bn.

And in terms of returns, it's one of the best performing asset classes this year, outstripping high-yield bonds. Leveraged loans, as measured by the S&P/LSTA Leveraged Loan index, have returned 4 per cent this year, while high-yield bonds have returned less than 1 per cent, per the ICE BofAML US High Yield index.

But beneath the boom lies an unsettling reality: lending protections are bad, and may be getting worse. In fact, they’re just about the weakest on record, according to a Moody’s gauge, which measures various metrics related to a lender’s ability to recoup capital. These include leverage requirements, the ability of borrowers to sell assets and collateral, among others.

Given these conditions, Moody's reckons recovery rates when the cycle turns will be much lower than in the past. Of course, we're not at this point yet. Economic growth remains robust, as does consumer confidence (now at an 18-year high). Default rates for leveraged loans sit at a paltry 2.4 per cent. So, hardly a crisis.

But when the downturn eventually comes, it's helpful to know just how lenders may get burnt.

In a new report, Moody's details the protections investors have been forfeiting. In the past, when companies' lacked maintenance covenants based on standard financial metrics such as maximum leverage and minimum interest coverage, they were deemed “cov-lite.”

But according to Oleg Melentyev of Bank of America Merrill Lynch, we're far beyond this point. So much so that the label is “outdated”, he says. In fact, nearly 80 per cent of new leveraged loan issuance falls into this category.

Here's a chart the IMF published Thursday showing this growth and worsening covenant quality:

A favourite ploy (and one of the most documented) is the ebitda add-back, whereby a company excludes certain expenses when calculating its earnings before interest, taxes, depreciation and amortisation — a metric often used as a cash flow proxy (and a bad one, at that). These can include one-off costs like those related to M&A activity, but also potential future savings from cost-cutting. By doing so, the company appears more creditworthy and can lever up even more without having to offer greater protection to lenders.

Beyond this, here are two other tactics that worry Derek Gluckman, the senior covenant officer at Moody's.

The first is collateral stripping. With this carve-out, borrowers can move assets outside of collateral pools and beyond the reach of senior creditors. Retailer J. Crew did this in 2016, sparking a new phrase for other companies trying to “pull a J. Crew.”

Another is the sidecar, or an incremental equivalent debt structure. This allows borrowers to pile on more debt that is on a “pari passu basis” or of equal seniority to existing leveraged loans. This creates a “competing lending class with equal priority claims,” points out Gluckman, which means should a loan run into trouble, there is “stronger competition for diminished recovery claims.” Lions Gate Capital Holdings, a subsidiary of Lions Gate Entertainment Corp — the film company behind cult classics like American Psycho and blockbusters like The Hunger Games — has one.

Gluckman is certainly not the first to raise concerns. In October Todd Vermilyea, a senior official at the Federal Reserve, sounded the alarm about these practices. With his remarks, he joined former Chair Janet Yellen, central banks in the UK and Australia, the International Monetary Fund and the Bank for International Settlements in decrying the leveraged loan market.

Some investors are now starting to tread more carefully. Despite being bullish on the sector, Andy McCormick, a fixed income portfolio manager at T Rowe Price, told us at the firm's briefing on their 2019 global market outlook that he's become a bit more selective about the credit he snaps up. Even with the Fed tightening and the American economy humming along.

While McCormick used to buy up every third deal or so, that rate has dropped to about 15 per cent, he said, as lending protections have fallen by the wayside.

George Goudelias of Seix Investment Advisors is similarly picky but still sees plenty of opportunity:

We've seen sponsors get a bit more aggressive, but there is enough paper to chose from that you don't have to participate in everything. Plus, if you are buying a good company with a strong business model, solid management and strong asset coverage, that'll trump a loose covenant.

Sure, whatever helps you sleep at night.

Related Links:
Warnings mount for leveraged-loan market — FT Alphaville
PetSmart's covenant mystery — FT Alphaville
Please don't tell individual investors to buy leveraged loans — FT Alphaville
The magic of adjustments: ebitla-dee-da — FT Alphaville