FT Alphaville noted last week that Citi analysts were predicting a return to the heady pre-crisis levels of leveraged buy-outs.
But, they argued, this time is kind of different: there will be fewer “mega-deals” (>$7bn) and the CLO business will be “a shadow of its former self.”
What does look familiar, as some commentators have recently pointed out, is the volume of covenant-lite loans. According to a Citi Global Structured Credit Strategy paper out Monday (emphasis ours):
Together with continuing spread flexing by borrowers, another sign of demand for yield by investors, is the increasing fraction of covenant-lite loans hitting the primary market. Indeed, among the institutional loan volume priced this year, cov-lites constituted about $14.3bn through Feb 15, representing roughly 25 percent of the issuance, which is at least as high as what we saw in 2006-2007.
Quick reminder: cov-lite loans — as their name suggest — offer lenders less protection via the waiving of financial maintenance covenants. These would otherwise require borrowers to maintain certain standards such as a maximum allowable leverage ratio or a minimum required interest coverage ration. (For a great take on this, see Steven Davidoff’s post on Tuesday.)
The rise of cov-lites during the liquidity-rich pre-crisis years raised concerns that struggling companies, which “should” have defaulted, survived when they would have collapsed in normal credit conditions.
Some eager eyes were on corporate default rates in 2008 to see if this would be a corporate version of the sub-prime mess. But this dog never barked, and the degree of protection (or lack of it) offered by cov-lites was never fully tested.
Citi analysts admit that cov-lite redux may make investors nervous. But, they add, there is little evidence that cov-lites perform particularly badly during crises:
First, as intuition suggests, loans with fewer covenants are less likely to default.
Sure, but as intuition also suggests, this is unsurprising if the loan’s strait-jacket has more wiggle room for the borrower. Davidoff adds that, according to Moody’s, there just wasn’t enough time to find out.
A better metric than defaults is recoveries, about which the analysts say there is little to go on:
Well, it seems that there is not enough evidence to suggest recovery on cov-lites is significantly lower than on regular loans. Indeed, some of the bigger cov-lites, such as Visteon, Citadel, and Six Flags saw a relatively high recovery, although we also saw a single-digit recovery in the case of another cov-lite, Aleris.
Bethany McLean writes in Slate that investors such as Blackstone claim cov-lites are actually better because they give issuers protection against lenders taking companies apart at the first sign of trouble.
But as FT Alphaville noted back in 2008, Citi analysts suspected then that lenders could find a way to punish weak companies if they really want. Which in turn suggests that the cov-lite default rate could spike if credit conditions deteriorated.
As you may have suspected by now, we don’t know very much at all about the safety of cov-lites. We may find out, though, with rates still super low and the search for high yield back in a big way.
Both the Citi paper and this piece by Mergermarket suggest that this time around investors are discriminating more against cov-lites. The latter reports that “issuers currently attempting to refinance existing covenant-lite loans with new covenant-lite facilities will likely pay at least 400bps in additional interest.”
So when the yields between them and regular loans converge, this could be a sign of the market overheating. Citi says the smart thing to do is to analyse, diversify and hire an expert. It also tries to reassure:
as Figure 3 shows, the market clearly discriminates against cov-lites, potentially building on negative perception.
But then here is “Figure 3″:
Watch that red line.
Related links:
Barbarians, back at the gate – FT Alphaville
Gillian Tett: Why corporate default rates will matter in 2008 – FT Alphaville
Covenant-lite loans are back but investors hope to limit mistakes of the past – Mergermarket
Corporate Subprime – Slate