Flashing lite - Ever-greater issuance of 'covenant-lite' loans is a warning sign for markets
A friend on Secondment in Los Angeles emails with an example of US hospitality – although the precise term he uses in connection with a recent offer of a mortgage with a 3.5% deposit, 4.5% interest fixed for 30 years and a salary multiple of 5.5x is “stupid lending”. “Repayments equate to 60% of my monthly pay,” calculates our green-cardless chum, “and that is considered normal!”
That little anecdote is unlikely to come as much of a surprise to regular visitors to The Value Perspective, where for some time now – in articles such as Offside indicator, PIK-ing holes and Fever pitch – we have been cataloguing evidence from the US of both aggressive risk-taking and a growing credit bubble.
The last of those three pieces, written in October 2013, flagged up how issuance of so-called ‘covenant-lite’ loans had reached an all-time high. As the name just about suggests, these loans impose less stringent terms on borrowers – for example, they may choose not to impose a limit on the total amount of debt a company can take on – which of course means they are much riskier for lenders.
As you might expect, a loan with fewer covenants enables a lender to ask for a higher rate of interest but demand for covenant-lite loans is actually being driven by the borrowers. At certain points in the cycle, a company will ask a number of investment banks to pitch for the chance to lend it money and the banks will have to judge an appropriate balance between interest charged and covenants imposed.
What happens is the banks start degrading the terms and conditions in the loans in order to seal the deal. Likened by some industry insiders to “death by a thousand cuts”, the pick-up in return from covenant-lite loans is rarely enough to compensate for the additional level of risk, which is why an apparent increase in issuance generally points to an inflating credit bubble.
According to data from S&P capital IQ quoted recently in this financial times article, close to two-thirds of the leveraged loans now sold into the US market contain fewer covenants than what might be considered standard. That is more than double the 29% level seen at the height of the leveraged buyout boom in 2007.
It would, however, be a mistake to view this as a US-specific phenomenon and the S&P capital IQ data also reveals almost €8bn (£6.6bn) of covenant-lite loans were arranged in Europe last year. That beats the previous peak of €7.7bn – again from 2007 – while the €2bn-worth already issued this year equates to one-quarter of all leveraged loans sold to institutional investors. in 2007, the figure was 7%.
The Financial Times quotes the US authorities as warning this lack of “meaningful” covenants is a sign “prudent underwriting practices have deteriorated” and suggests they may have in mind the words of former Citigroup boss Chuck Prince, who in 2007 dismissed fears of loose lending standards with the infamous line “as long as the music is playing, you’ve got to get up and dance”. In contrast, here on The Value Perspective, if we do not like the music, you will not find us anywhere near the dance floor.
Fund Manager, Equity Value
I joined Schroders in 2004 as an equity analyst in the European Equity Team initially specializing in the Industrial sectors before moving on to Consumer-based companies and finally Insurance. In 2007, I became a co-manager on a fund investing in undervalued European companies and took on sole responsibility for the fund in May 2010. Prior to joining Schroders, I worked at Hedley & Co Stockbrokers and Deutsche Asset Management as a trainee analyst.
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