Managers fret over protections that grow increasingly fragile
Money management executives around the globe are becoming increasingly concerned over aggressive terms and the proliferation of weaker covenants within the popular leveraged loans asset class.
Analysis by leveraged finance data firm Debt Explained, London, found the leveraged loan market in 2017 was dominated by so-called covenant-light terms, with less restrictive terms on these deals.
The firm said covenant-light deals in Europe accounted for 52% of the total last year, vs. 37% in 2016. Debt Explained said a European leveraged loan deal traditionally carried four or maybe five maintenance covenants — the number of financial levels a debtor would have to maintain such as interest cover, cash flow and leverage ratio. But in this new era, that has been reduced to just one covenant, with even that not applying until a trigger is hit.
Sources at money manage- ment firms noted that Europe is in the later stages of the credit cycle, although not as far along as the U.S. They estimated that about 75% of U.S. issuance is now covenant light.
"Every cycle, the seeds of ruin are sown in the sunshine," said Peter Aspbury, head of European high yield at J.P. Morgan Asset Management (JPM) in London. "Now potentially a bit of complacency has set in precisely because the prospects for issuers have been fundamentally sound. We see that complacency more than anywhere else right now ... in the way covenants are set."
The loan market "used to pride itself on its relative strength and credit protections" vs. the bond market, but "demand for that asset class has meant it has surrendered that relative level of protection," Mr. Aspbury said.
Added Fraser Lundie, co-head of credit at Hermes Investment Management in London: "People are correctly pointing out that covenant weakness or covenant light is probably at its most prevalent right now vs. the rest of the cycle. Not that it hasn't been quite poor already the last two years."
He said one takeaway from this situation is "lower recovery rates in a default scenario," because some covenants allow companies to prolong their lives in different ways. "That type of activity wouldn't have been allowed in previous cycles," added Mr. Lundie.
Part of the reason behind weaker covenants is demand, with European leveraged loan funds attracting €9.2 billion ($11.5 billion) in assets in 2017, compared with €3.5 billion in 2016, according to data from Lipper.
"Covenants have loosened, structures have become more issuer-friendly for sure," said Marc Kemp, institutional portfolio manager in the leveraged finance team at BlueBay Asset Management LLP in London. "We probably won't see that show up in defaults or lower recovery rates for a couple of years," he said, with the structures in Europe today probably not regretted until "a couple of years down the road. There will be a point where you kick yourself a little as a market and say, 'I wish we'd been more disciplined,' but that is multiple years away."
'Are we worried? Yes ...'
Rachel Golder, New York-based co-head of the high-yield and bank loan team at Goldman Sachs Asset Management, said the team is concerned. "Are we worried? Yes, we're concerned that this credit cycle has seen covenant light migrate from the highest quality companies to all but the most risky." Pre-global financial crisis, she said, there was "no material difference in the behavior of companies with light covenants, or in their experience in stressed markets; but we would maintain this largely results from the higher quality cohort" at that time.
There are a number of implications of covenant-light terms in the now larger proportion of instances. "Potentially worse credit deterioration before an event of default occurs, resulting in higher debt, lower enterprise values and ultimately lower recoveries on both loans and bonds upon default; more aggressive corporate behavior that can drive a wedge between the interests of owners (or) managers and their lenders; and the absence of a formerly noteworthy stream of fee income due to amendments and waivers," Ms. Golder said.
Sources said there are other trends at play causing some concern.
"We are concerned about covenant-lights, but I think there's a concern more broadly about bank loans today," said Mark Cernicky, managing director, portfolio manager of Principal Fixed Income at Principal Global Investors LLC in Des Moines, Iowa. "The covenant packages certainly have weakened, they've actually blurred the distinction between bonds and loans, and to some extent floating-rate high-yield looks pretty similar to a bank loan. That blurring has taken one of the advantages of loans over bonds — that as you get later in the credit cycle you have the ability, through the covenant, to get protection."
Mike Scott, fund manager, fixed income at Schroders PLC in London, said weaker covenants are something to be taken seriously, "and it's why you need to have a very strong, analytical base if you are investing in the asset class. It is not something that is easily understood. We find that some of the structures are not … in the interest of the investor … for instance we're seeing more prevalence of shorter-call paper," particularly in the floating-rate market, so if a company does well investors may not benefit from capital appreciation in the way they would with longer-call structures.
Mr. Scott and other money management executives also are concerned about the ways issuers might be presenting earnings before interest, taxes, depreciation and amortization. Through add-backs or adjustments to this EBITDA figure, companies might be putting deals or transactions in a more positive light, they said.
The use of EBITDA adjustments allow the conventional calculation of profitability to be inflated to make leverage lower than it actually is. Olivier Monnoyeur, high-yield portfolio manager at BNP Paribas Asset Management in London, said the gap between reported EBITDA and adjusted EBITDA has gradually expanded, resulting in increased risk for investors.
JPMAM's Mr. Aspbury added the nature of these so-called add-backs is "increasingly aggressive."
But there are signs investors and money managers have had enough when it comes to the terms on offer, and are increasingly willing to fight back. Sources said there have been a number of deals early this year around the globe where investors pushed back on terms, negotiating on covenants and terms.
"This year is probably the first time we've seen a bit of pushback from investors" against the weaker covenants that are "creating the problems of tomorrow," said Mr. Monnoyeur. Defaults would appear in about three years, "so it is now (investors) need to be more cautious."
"In my mind, a number of the recent pushbacks have come largely because the pendulum has continued to swing in the direction of the issuer," said Jeff Boswell, co-head of multiasset credit at Investec Asset Management in London. "The quality of the (documentation) we're seeing is undoubtedly at a cyclical weak point. In terms of the next default cycle, it means a number of issuers that probably would have defaulted are allowed to struggle on."
Mr. Boswell said investors need to "get a good handle on the risks" they are taking, analyzing the legal risk as well as corporate and credit risks.