By Venk Reddy
Originally published in Q3 2018 letter
During the course of hundreds of conversations we have in any given year with clients, prospective clients, A lot has been written in the financial media about the return of “covenant lite” loans. Many market participants remember correctly that there was a spike in such loans before the last financial crisis in 2008, and this trend was cited then as a sign that the syndicated loan market, a once sleepy and supposedly safe corner of fixed income, had become unsustainably risky. When characterized this way and given what eventually happened to the capital markets, who could disagree?
Strictly speaking, the term “covenant lite” specifically refers to the absence of a specific restriction on a company’s ability to issue debt. Depending on the type of debt issued, including the level of risk perceived by debtholders, a bond (or loan) would have either an incurrence or a maintenance covenant. The incurrence covenant places a restriction on the amount of leverage a company can have when it issues a new debt instrument. Put another way, if the company’s leverage was, say, 3x EBITDA1, an incurrence covenant might say the company can only issue new debt if that debt resulted in leverage at the time of incurrence was below, say, 4x EBITDA. However, once the debt was issued, if EBITDA subsequently declined in a future year so that the company’s leverage exceeded 4x EBITDA later on, this would not constitute a default under the debt’s covenants.
If this 4x EBITDA requirement was written as a maintenance covenant, the company would be required to maintain that level of leverage at all times. Even a single instance of leverage exceeding the covenant, whether due to the incurrence of new debt or due to a decline in EBITDA in a subsequent period, would constitute a default. Such maintenance covenants have traditionally been standard in debt issued by companies with high yield credit ratings. Because the risk of excess leverage is one associated with the issuer itself, not the type of debt it issues, the credit agreements governing syndicated bank loans issued by high yield companies2 have historically also included maintenance covenants. Until they didn’t. The trend in the years leading up to the 2008 financial crisis and again in recent years now of dropping the maintenance covenants from loan documents is the specific meaning of the “covenant lite” label.
However, the absence of maintenance covenants doesn’t mean that the loans are not without protections. A variety of secondary covenants, such as an explicit limit on increased borrowing or restrictions on paying dividends to shareholders, often do a better job of getting to the true heart of the question facing credit investors: Are there restraints on cash exiting the business in a way that puts the ability to repay debt at risk? If such restrictions exist, the creditworthiness of a particular loan may be validated regardless of the existence of a maintenance covenant. On the other hand, the existence of maintenance covenants don’t necessarily add value or protection to a weak credit; they may simply serve to accelerate a default.3
That said, the renewed focus on “covenant lite” loans is not misplaced, but not because the loans are missing maintenance covenants. The indiscriminate buying that has characterized the loan markets in recent times has created a seller’s market for such securities. As a result, issuers are able to whittle away at even the more meaningful cash flow restrictions elsewhere in the loan documents. Why? Because the intersection of the overwhelming trend toward passive investing and the huge demand for a place to hide from rising interest rates has created an unprecedented volume of demand from investors (and the managers they hire) who buy securities in bulk without reading the governing documents. The need for exposure to the asset class as a whole irrespective of issuer creditworthiness has drowned out the more selective loan investors who view creditworthiness over time as a prerequisite to making an investment.
Unfortunately, we don’t see this trend subsiding without a significant correction at some point, but the conventional wisdom dominating the headlines isn’t the real story here. “Covenant lite” isn’t why investors should be worried about the loan market. The credit risk in the current market is driven by the lack of attention being paid to other credit protections because investors are treating the entire loan market as one homogenous asset class.
Even so, the fact remains that the general characteristics of syndicated bank loans are as advertised. In particular, they have lower interest rate durations while offering reasonable yields. One can benefit from this profile by recognizing loans as the credit instruments they are, and a responsible use of such securities requires at least some level of credit analysis to inform security selection. It is no more valid to throw out the entire loan asset class for a general trend toward weaker covenants than it would be to exit all equity investments because trade tariffs threaten a subset of stocks. On the other hand, it would make no more sense to buy the entire asset class indiscriminately and then wonder why it didn’t do what it was supposed to do when interest rates and credit spreads increased. Weaker covenants in general don’t impact all loans equally, and not all loans are being undermined by weaker covenants. But to be able to make this differentiation is an exercise in security selection, not asset allocation. In other words, only the fundamental debt buyer is doing what it takes to spot the difference.
We are encouraged every day by the thoughtful and informed discussions we have with our readers, and we invite you to view this as an invitation to engage with us further. We are hopeful that our perspective is helpful and, more importantly, actionable. We believe it is essential not just to know that risks exist but also to understand why they are risks in the first place, and by extension, to consider how one might prepare for them. After all, there is no free money: Achieving any return is an exercise in choosing to take some risk. It is this understanding of the “why”, not just the “what”, that enables investors to act with clear heads and rise above the emotional reactions that plague so many and can be so costly in times of volatility.
1 This means that the company’s total debt outstanding can be no more than three times its reported earnings before interest, taxes, depreciation and amortization (EBITDA). Companies can often have ways to adjust these numbers before calculating leverage, so a detailed credit investor will often look for the loopholes in the definitions of both debt and EBITDA before trusting a number provided by an issuer.
2 Note that most of the bank loans dominating the marketplace today are issued by high yield companies, in part because they are the highest yielding and in part because investment grade loans are not often syndicated beyond lender pools consisting solely of banks.
3 Accelerating a default before things get worse has its benefits to debtholders, to be sure, but making a badly-run business creditworthy is not one of them.
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Zeo Capital Advisors is a fundamental investment manager with a short-duration credit mutual fund, a sustainable high yield mutual fund and separately managed accounts. Venk Reddy authored this piece and is the Chief Investment Officer and founded Zeo Capital Advisors in 2009.
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