The hard sell

Covenant-lite loans make up an increasing part of collateralised loan obligation (CLO) portfolios. But the reduction in covenant protection has sparked concerns that lower recovery rates for cov-lite loans could cause increased loss exposure for CLO investors in a credit downturn. Radi Khasawneh investigates


The boom in covenant-lite (cov-lite) loans is starting to have a noticeable effect on collateralised loan obligation (CLO) portfolios. With cov-lite loan volumes exploding in the first quarter of this year, CLO managers are increasingly turning to these assets to use as collateral in their portfolios.

Cov-lite loan volumes reached $48 billion in the first quarter of 2007 - double the figure for the whole of 2006, according to Standard & Poor's Leveraged Commentary and Data. While only a small proportion of CLOs originated in 2006 had more than 10% of their portfolios invested in cov-lites, more than 80% had exposures of less than 5% of their collateral, says S&P. That number is likely to have grown substantially this year in tandem with the rise in volumes in the primary market.

Cov-lite loans typically have incurrence covenants rather than maintenance tests. In essence, maintenance covenants require a borrower to meet certain financial tests at regular intervals - for instance, earnings before interest, taxes, depreciation and amortisation, leverage or debt service coverage. Incurrence covenants are considered less restrictive as they merely require a borrower to stay within certain thresholds if it takes a specific action.

However, analysts claim the absence of maintenance tests mean the early warning signs given by the breach of a performance covenant are removed. Consequently, the lender has less of chance to restructure a loan if it experiences difficulty and less opportunity to mitigate potential losses.

In fact, some analysts claim the erosion of covenant protection could lead to lower recovery rates on cov-lite loans if defaults occur, potentially increasing risk for CLO investors. This has prompted investors to look closely at their investments and rating agencies to review their CLO rating criteria to reflect the expectation of increased loss exposure on cov-lite loans.

The problem for CLO managers is they have little choice in the loans they can invest in. The type of assets that managers can include in their portfolios is driven by the loans that come to the primary market. In the US, that primary issuance is increasingly dominated by cov-lite loans, while the European market is seeing an increasing number of jumbo big-name loans adopting this structure.

"If you look at it now, I would say the vast preponderance, if not all, the transactions are cov-lites," says Mark Gold, founding partner at Hillmark Capital, a New York-based CLO manager. "Of those transactions with covenants, I would say that around 50% of those deals have two or fewer covenants in them."

Very few CLO managers like to invest in cov-lite loans, as they are in less of a position to control a workout situation. However, managers have little option if they want to remain fully invested.

"You can't really be in the business if you are not buying cov-lite these days," says Gold. "It is just about impossible to assemble a portfolio of loans without having some percentage of cov-lite deals given the state of the market and what exists today. When you look at all the huge transactions that are coming down the road, the vast majority of them are cov-lite transactions. If you look at transactions that have covenants in them, you begin to question what is wrong with the transaction. It's almost a perverse type of situation we are in right now."

The bigger, more experienced CLO managers tend to have better relationships with lenders and are able to get larger allocations in loans with traditional covenants. Even so, some of the larger CLO managers are sitting on the sidelines.

"Some of the more experienced managers, with a proven track record, do not mind forgoing equity returns in order to maintain a stable profile throughout the life of the deal," says Dov Warman, a portfolio analyst at Dynamic Credit Partners, a New York-based CDO manager. "If the leveraged loan market eventually shows serious signs of weakening in defaults and recoveries, these managers will most likely outperform their peers both from an equity and debt perspective. They don't feel as much pressure to buy cov-lite loans."

Smaller managers looking to establish themselves in the burgeoning CLO market, however, need to remain fully invested in order to achieve the promised level of equity returns. And despite the possibility of lower recovery rates and higher potential losses on cov-lites compared with senior secured loans, there is currently little pricing differential between the loan structures.

That is, in part, a function of the liquidity of the market. There has been a huge influx of new players into the leveraged loan market. According to Standard & Poor's Leveraged Commentary and Data, non-bank lenders - CLO managers and hedge funds - now account for more than half of all activity in the leveraged loan market, and 75% in the US. The rise in competition has driven down spreads on leveraged loans, and encouraged lenders to forgo charging a premium for reducing the number of covenants on loans.

"What you have found is that cov-lite is coming into the term loans, with sponsors willing to pay a premium to be cov-lite," says Gold. "If you look at it historically, the market has not commanded a premium of any materiality from being in a cov-lite transaction, despite the fact that we believe the sponsors are willing to pay for that. That gives you a sense of the hyper-liquidity of the market-place."

As the credit cycle turns, this pricing discrepancy is likely to be addressed - but for that to happen, there must be actual defaults. If defaults don't occur, this type of structure actually has some benefits. Cov-lites are structured much like high-yield bonds, which also typically have incurrence covenants. If there is less pressure on performance mechanics and cashflow by reducing leverage covenants and back-ending the debt, the borrower has greater flexibility to ride out difficult or volatile markets.

Back-ended loans mean the principal is paid back at maturity, rather than gradually throughout the loan's life. That frees the cash in the loan structure for longer, and with no performance covenants, means that there is less pressure over the crucial first two years of the loan. Similarly, the increase of 'toggle' covenants, where the subordinated debt can be transferred into payment-in-kind notes, has the same effect. In those notes, the sponsor can opt to capitalise the interest payable on eligible notes rather than service those loans conventionally.

Nonetheless, the rating agencies believe the rising proportion of cov-lite loans in CLO portfolios exposes investors to higher potential losses. In particular, S&P argues that while many cov-lites are technically senior secured first-lien loans, that may be misleading from a potential loss standpoint. In other words, they are assigned relatively high recovery rates in CLOs because of their senior secured first-lien loan status, while eroding the covenants that caused the sector to be assigned such high recovery rates in the first place.

As a result, the rating agencies are reviewing their rating methodologies. The issue is not one of probability of default - it is a matter of the recovery rates that can be assigned to such loans and the increased risk that should be ascribed in the event of default. In simple terms, a default is no more probable, but should one occur, the severity of default and effect on probable recovery increases.

S&P, for instance, is building on its asset-specific corporate recovery rating (RR) approach to reflect the popularity of cov-lite loans. It has extended its RR scale from 1+ (full recovery) to 6 (0-10% recovery), and will introduce a number of new approaches for CLO managers not using the RR-based platform from August 31. In particular, it will apply a 10% haircut to its tiered corporate recovery rates for cov-lite loans.

Fitch Ratings, meanwhile, always assigns an issuer default rating of RR4 to a leveraged loan, which translates into an expected recovery rate of between 31% and 50%. This figure is then notched up or down, depending on the section or tier of the debt structure included in the portfolio. As the notching approach is based on enterprise value and instrument specific recovery, there is no specific application for cov-lites.

In essence, Fitch looks to its performance monitoring to capture factors of concern in lieu of breaches that would have occurred in a maintenance covenant. As much of the European leveraged loan, second-lien and mezzanine markets are private, the rating agency provides a shadow rating on the underlying leveraged loans for asset managers, so their securitised notes can publicly rated. This shadow rating relies on information flow from the borrower through the asset manager to the rating agency. That flow tends to take the form of six monthly updates, rather than ongoing monitoring.

"While the analytical and committee process are the same, the shadow ratings that support CLO ratings are information-deficient relative to our public ratings, which is why they are always accompanied with an asterisk when delivered to asset managers," explains Edward Eyermann, managing director in leveraged loan surveillance at Fitch Ratings in London.

One problem the rating agencies face is a lack of data. Only $27 billion of cov-lite loans were printed between 1997 and 2006, according to Standard & Poor's Leveraged Commentary and Data, meaning there is little historical recovery rate or loss data to analyse. Another difficulty is how to define cov-lite loans. Treating covenant-lite structures as a stand-alone asset class with separate assumptions raises the potential for ratings arbitrage.

"We recognise that this is a complex issue and that our proposed definition is binary with respect to merely defining cov-lite as a loan that does not have a maintenance test with financial triggers," acknowledges David Tesher, a collateralised debt obligation analyst at Standard & Poor's in New York.

Defining cov-lite loans as those without any maintenance or financial triggers may provide incentives for market players to incorporate a loose maintenance covenant. These 'cov-loose' transactions, as some have called them, are already in the market, muddying the waters.

"Cov-lite has become a definition of art as opposed to science," says Gold. "There are covenants and there are covenants. One can put a covenant in a transaction that is so wide that from a practical perspective it is cov-lite. So, what we are doing is to drill down and understand how meaningful the covenants in place are. Having a maintenance covenant that is wide from our perspective is the same thing as having a cov-lite transaction."

As such, the approach taken by S&P to discount expected recovery rates on loans defined as cov-lite is conceded as an initial step, and the agency is soliciting feedback from the market on the definition and treatment of these loans. The end point could be prescribing restrictive covenants or even maintenance tests by category, capping debt levels and cashflow, and restricting incurrence of additional debt.


"In practice, however, this would be challenging to implement across the board because loan covenants are not homogeneous, definitions can be gamed, and the relevant headroom or limit is difficult to quantify," says Tesher.

Others, however, argue the dominance of cov-lite loans in the primary market is temporary and may change as institutional investor demand cools. "As the S&P report points out, the number of cov-lite deals being done is still very much in the minority," says Tim Polglase, head of leveraged finance at law firm Allen & Overy in London. "Cov-lite is a function of institutional investor demand, since banks have been less keen than non-bank investors on holding cov-lite paper. If demand from non-bank lenders weakens, then the growth of cov-lite is likely to slow or possibly even reverse."

That demand, however, has been rock solid for the past two years. The sense from CLO managers and investors is less that they are keen on cov-lites, but that they simply can't be avoided in the US and will increasingly become a fact of life in Europe.

"Of course, we look at the covenant package when sourcing assets because that is our safety net," says a London-based CLO manager. "If we see a very good company with a cov-lite package, then you can justify it. The difficulty comes where you have weaker companies with a cov-lite structure on top. The combination can lead to weaker investments and that is the concern."

And it's not just new CLO deals that will have increased exposure to cov-lite loans. As older vintage deals are refinanced or enter into dividend recapitalisation, the exposure in existing portfolios is likely to increase. It means managers will have to look carefully at the covenants on the various loans in their portfolios.

"To look at it from a broader perspective, there is a lot of buzz around cov-lite loans but there is still not a standard market definition for exactly what that entails," says Jack Chen, chief operating officer at Hillmark Capital. "I think any prudent manager needs to look at the specific covenants for each loan, how meaningful they are and how that stacks up against the company's financial situation as it stands today."

Dynamic Credit Partners has just undertaken a review of its cov-lite exposure across vintages. "Issuance of cov-lite loans in the US is a lot higher compared with last year, considering the current market supply and demand dynamics and the need to put as much cash to work as possible," says Warman.

As both a manager of and an investor in CLO portfolios, Dynamic Credit is well placed to make an assessment of the risk in its portfolios. Some investors, however, simply cannot make the kind of subtle loan-level analysis that is necessary on underlying portfolios.

"Based on the feedback and discussions with several CLO managers, investors are not yet paying enough attention to the nuances and risks associated with cov-lite loans in the context of managing a complex CDO structure," says Warman.

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