This could have direct implications during the next credit cycle: While we expect the higher use of cov-lite loans would force fewer companies into default, loan recoveries—collection on payments to the lender—will also be lower than long-term averages.
The evolution of covenants in the loan market
Before breaking down the potential implications of today’s market, it’s important to understand the context of how we got here. Entering the 2008 global financial crisis, over 80% of the loan market was considered covenant heavy.1 These loans required strict maintenance covenants that were tested on a periodic basis to assess leverage, interest coverage, and capital expenditures.
It may seem counterintuitive to suggest that more restricted loan provisions could lead to more defaults, but that’s what we believe occurred. In our view, the existence of multiple covenants created near-term triggers that pushed companies into restructuring that otherwise may have been able to weather economic storms and avoid default.
From what we see today, we don’t expect history to repeat itself during the next credit cycle. In our view, the higher use of cov-lite loans—which now make up more than three-quarters of the market value of loans—effectively lowers the number of maintenance covenants that can be tripped.2 This suggests that a greater number of companies could remain operational, even if the macroeconomic backdrop deteriorates.
Prepare for lower recovery rates along with fewer defaults
Looking forward, while we believe that overall defaults will be lower than in past downturns, we expect that recoveries in first-lien loans (the first tranche of borrowers to receive payment in case of default) and junior capital (unsecured high-yield bonds and second-lien loans) will also be lower than we’ve seen in the past. Specifically, we’d expect to see lower rates than the historical long-term recovery rates we saw for first-lien loans (73 cents) and cov-lite loans (71 cents) between 1987 and 2017.
Incorporating covenant analysis into our research process
As a manager of loan portfolios, we believe that mitigating risk for lenders relies on diligent document analysis—a practice we’ve long considered a key part of our investment process. When used alongside fundamental research, we view the combination of these two elements as the best strategy to minimize defaults and maximize recoveries.
We begin our document reviews with a detailed evaluation of a company’s expected behavior, which we determine by conducting a thorough analysis of its ownership base, management or growth strategy, pattern of managing leverage, plans for divestiture, expectation around revenue growth, and other relevant factors.
Next, we review the covenant documentation to ensure that collateral remains pledged to term loan holders—one of the most important diligence items. Specifically, we assess restricted payment provisions, incremental debt baskets, subsidiary terms, and a few other clauses that we believe matter most for lenders.
The goal of our document review is twofold: to give us a clear view into how well the existing covenants might protect the lenders’ investment and to identify what we call collateral leakage—agreements that carve out assets not available to the lender. Once we understand these variables, we’re able to select companies for our portfolio that meet our rigorous criteria.
Covenant analysis can be a source of conviction in uncertain markets
The growth in cov-lite issuance is a topic our team discusses regularly. Even though we expect stringent covenants to play a more muted role during the next market downturn—as fewer companies declare bankruptcy—our investment process continues to emphasize preserving value through diligent review of covenant agreements. We believe this step can help mitigate risk and enable us to be opportunistic, even in times of market uncertainty.
1 Leveraged Commentary & Data (LCD), an offering of S&P Global Market Intelligence. 2 Chart data, as of February 2019. LCD, an offering of S&P Global Market Intelligence.