Managers should warn on loan risks
Three-quarters of all outstanding leveraged loans lack meaningful lender protection. This is the outcome of the steep rise of ‘cov-lite’ loans since the financial crisis. Cov-lite loans lack maintenance covenants, the provisions that require borrowers to pass regular tests of their ability to sustain loan payments. Incurrence covenants are still present. This means that borrowers have to show financial fitness before taking unplanned actions, like paying an extra dividend or making an acquisition. But the loan market overall is potentially riskier than before the crisis. Granted, default rates are low, valuations are reasonable, albeit becoming stretched, and the strong economic environment supports borrowers.
However, when times get tougher, credit investors will face serious headwinds. Without maintenance covenants, there is no mechanism to get reckless borrowers and concerned lenders around a table to prevent defaults. Investors may indeed be caught out by rising defaults.
This is a sad story that mirrors what happened in the run-up to the last crisis. It is the result of many concurrent factors that have created excess demand for credit investments. Borrowers and their advisers have exploited this situation by aggressively demanding flexible terms, and investors have obliged.
There is trouble brewing in the markets and perhaps not enough discussion of it. Most credit managers try to reassure investors saying that what counts in a loan investment is how leveraged the company is overall and the strength of its business. They will say that there is nothing to worry about as long as the economy stays strong. They will argue that corporates that have not been able to get flexible loan terms are in fact the riskiest investments, because the market is not as comfortable with their businesses. This is a good example of the paradoxical nature of financial markets.
“When times get tougher, credit investors will face serious headwinds”
Sensible managers, however, should warn investors about the risks and come up with solutions. Investors and managers need to team up and show that preferences are shifting. They should resist demands for flexibility of loan terms.
It may be difficult to turn the tide at this point but their action may at least prevent further dilution of loan covenants. Borrowers are in fact demanding more flexibility on fundamental terms such as the measurement of expected earnings.
Time is of the essence. Investors should act now, in a counter-cyclical fashion, before the credit cycle runs its course and loan assets lose value owing to rising defaults and recovery rates. They cannot allow a preventable disaster to happen.
When the next crisis eventually comes credit managers must be able to show that they at least tried to limit the damage.
Carlo Svaluto Moreolo, Senior Staff Writer