An explanation of cov-lite loans

I have been arguing for some time that the risk emanating from cov-lite loans is probably overhyped. As I have stated in both our recent “The Joy of Structured Finance” and our “Market Outlook Q2 2019” the covenants of cov-lite loans are very similar to high yield bonds, and so investors who are familiar with high yield bonds should not be too worried about all the stories on the subject of how cov-lite loans will create the next financial crisis.

However, I realise that I have never really explained in detail how cov-lite loans are like high yield bonds. Something that needs to be corrected, obviously.

Traditionally, senior loans were issued by banks to borrowers with high financial leverage. Unlike high yield bonds, senior loans are not subject to security regulations and not traded in a regulated secondary market. As a result, banks were taking on real underwriting risk while investors in high yield bonds were subject to price swings in secondary markets but could rely on legal protection like the applicable bankruptcy laws. Banks, who for obvious reasons were eager to protect their loans, insisted on a range of covenants that we have listed in our primer on senior loans. The most important covenants for our purposes were four typical maintenance covenants that covered how certain financial ratios had to be maintained during the lifetime of the loan. If one of these covenants was broken this would trigger a technical default and the need to repay the loans within 30 days.

Since the last financial crisis, the investor base in senior loans has shifted away from banks to non-traditional source of financing like CLOs and institutional investors. Institutional investors in particular look at senior loans more from a yield perspective than from a perspective of preservation of capital. Since institutional investors were familiar with the terms of high yield bonds, the terms of newly issued senior loans increasingly resembled those of high yield bonds.

This shift in the investor base meant that maintenance covenants were reduced and today, cov-lite loans typically have just one maintenance covenant in place, namely the need to keep the net leverage ratio below a certain threshold. Sometimes a second maintenance covenant, the need to have a minimum interest cover, is added. High yield bonds, on the other hand, have no maintenance covenants whatsoever and only a limited number of incurrence covenants. This is what I mean when I say that cov-lite loans have similar protection against default as high yield bonds. In fact, thanks to the last remaining maintenance covenant, cov-lite loans trigger a technical default if the net leverage ratio is violated, while high yield bonds do not.

The result is that cov-lite loans now combine features of traditional senior loans with features of high yield bonds, as summarised in our chart below. Cov-lite loans, like senior loans, are typically floating rate in nature and securitised against assets of the company, while high yield bonds are typically fixed rate bonds and unsecured. While this provides additional security to loan investors, the fact that the secondary market for high yield bonds is much more liquid than for loans means that loan investors still have to face liquidity constraints and in the event of a market crisis, it is essentially impossible to sell the loans to other investors. Investors therefore need to have the ability to hold on to these loans throughout a period of market dislocation.

On the other hand, investors in cov-lite and traditional senior loans have better protection in case of a bankruptcy of the issuer than high yield bond investors because of the securitised nature of the loans and the remaining covenants over and above the covenants for high yield bonds. Traditionally, loans were also subject to so-called “Most Favored Nation” rules (MFN, a term borrowed from international trade) that ensured that an existing lender was entitled to at least as favourable terms as any subsequent lender. These MFN protections have never existed in high yield bonds and are now becoming increasingly inapplicable in certain types of incremental loan issuance – another step on the path of convergence between senior loans and high yield bonds.

Comparison between senior loans, "cov-lite" loans and high yield bonds

Source: Fidante Capital.

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