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Breaking the covenant

Paddy Hirsch Nov 21, 2012

Warning! 28 percent of leveraged loans are now covenant-lite!

Umm… OK, but what the heck does covenant-lite mean, you ask. And what’s a leveraged loan? And, while I’m at it, why should I care?

All great questions! A “leveraged loan,” also often known as a high-yield loan (if you’re talking dirty, a junk loan), is a risky loan, borrowed by a company that’s heavily in debt. Because of the risk, leveraged loans come with high interest rates. They also usually come with covenants, which are rules and benchmarks that the borrower has to meet every month, things like minimum debt-to-earnings ratios and such. Covenants act like canaries in the coalmine for lenders, giving them early warnings that a company might run into trouble and possibly default on the loan. You can see a Whiteboard explaining covenant-lite below.

Recently lenders have allowed many companies to strip out covenants from their loans. Borrowers are happy about that because it makes the loans easier to live with – no pesky rules and regs to follow – just pure money. But it means there are a lot of loans out there now with very few early warnings in them. The last time this many so-called covenant-lite loans were in the market was in 2007.

Covenants are designed to protect lenders, so why are they allowing borrowers to get away with this? Because they need yield. With rates so low, lenders are finding it tough to make decent returns. So in their thirst for yield, they’re prepared to do whatever it takes to get people borrowing at rates that will help investors make money.

Why should you care? Because it means that risk is being baked into the system again. Leveraged loans are already risky. When they’re structured with few covenants, they’re riskier. And we all remember dangerous unfettered risk can be … don’t we?

Cov-lite loans are back! from Marketplace on Vimeo.

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