Bank lending to companies with few restrictions has surged back since the financial crisis virtually killed the practice.
The record issuance of so-called covenant-lite loans raises questions over whether a fresh wave of debt defaults and losses will return—probably not in the short term, according to experts, but becoming more likely as the trend plays itself out in coming years.
U.S. “cov-lite” loan volume recently hit $83.6 billion over 82 deals in 2014, up 41 percent from the same period in 2013 ($59.4 billion over 68 deals), according to data tracker Dealogic. That represents the highest year-to-date volume and deal activity on record.
Credit Suisse leads the U.S. for such loans with a 12.8 percent market share in 2014, according to Dealogic. The Swiss bank is followed by Citigroup and Deutsche Bank with 11.5 percent and 10.8 percent of loans, respectively.
Cov-lite loans usually offer investors returns of about 3 percent or 4 percent today. Covenants vary, but they are often tied to corporate debt levels. If a company borrowing money—often backed by a private equity firm—violates one of the loan covenants, the lender can request its money back or charge a higher interest rate.
The surge in cov-lite doesn’t surprise observers.
“When you get this far into the business cycle, this is what happens. It’s as simple as that. History doesn’t repeat itself, but it rhymes,” said Jack Flaherty, an investment director for $129 billion GAM’s fixed income investment team.
Flaherty said he doesn’t have an allocation to cov-lite loans but also isn’t worried about a blow-up in the near future. “I don’t think there’s any reason to say this is going to fall apart soon,” he said. “There’s still too much money sloshing around.”
Still, the surge of covenant lite loans is problematic for some.
“Covenants have been stripped away, cov-lite is the norm, senior debt levels are actually higher than they were in 2007,” Marc Rowan, co-founder of $159 billion Apollo Global Management, said in May at the Milken Institute’s Global Conference. “I do see many signs of the bubble of the future—the default specter that you’re talking about. I agree that short term we’re not likely to see that, but all the danger signs are there of a future crisis.”
Matthew Litwin, director of research at wealth advisory firm Greycourt & Co., also urged caution.
“We have been getting more cautious on loans across the spectrum, including cov-lite,” Litwin told CNBC.com. “Even if mass defaults aren’t imminent, there’s just too little reward for the risk of having only a couple strings attached.”
Not everyone, however, thinks cov-lite should be avoided.
“Nothing is attractive. Bank loans are trading at low single digits. It’s a matter of pick the poison and hold on until the correction comes,” said Michael Lewitt, a bond investor and editor of The Credit Strategist.
Lewitt said problems with such loans aren’t likely before 2016, leaving many months of positive, albeit low, returns in parallel with continued low interest rates.
“That’s just the game right now,” he said. “It’s just a matter of what’s least offensive when you’re trying to put money to work.”
Other observers point out that cov-lite doesn’t always equate with poor businesses.
“Cov-lite does not mean ‘no covenants’ nor does it necessarily indicate reckless lending practices,” Robert Kinsey, a portfolio manager at OppenheimerFunds, noted in a May report. “We see the increase of cov-lite loans and the loosening of restrictions as yet another measure of increased investor risk appetite—less fear of uncertainty—and stable to improving credit fundamentals of borrowers.”
That’s similar to a point made by Loomis Sayles on the lack of correlation between covenants and financial performance.
“Our view is that a high-quality credit might not be impacted by a maintenance ﬁnancial covenant because it would not likely have violated the covenant even if it had one,” the money manager said in a report last year.
“We feel that from the perspective of a lender, it is more desirable to own a good covenant-lite loan than hold a bad credit with a maintenance ﬁnancial covenant,” the report added. “Therefore investors in loans should be far more interested in the credit skills of their managers than the proportion of covenant-lite loans in a portfolio.”
The performance of cov-lite loans through the financial crisis supports the point.
While the values of the loans plunged along with other assets, the wave of anticipated defaults didn’t materialize. And the recoveries of loans that did fail were better than those that gave management teams less flexibility to turn around their companies.
From the fourth quarter of 2008 to the first quarter of 2011, lenders recovered 89.6 percent of first lien loans that emerged from default, according to Moody’s. That was better than an 81.5 percent rate for covenant-heavy loans.