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 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."