Felix Salmon smackdown watch, cov-lite edition

June 2, 2013
my piece on cov-lite loans came out, he published his own, coming to much the same conclusion.

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Stephen Foley was clearly thinking along the same lines that I was on Friday: shortly after my piece on cov-lite loans came out, he published his own, coming to much the same conclusion. (But expressing it better: I love “the bearable liteness of covenants”.)

Not everybody was convinced, however. David Merkel has the meatiest pushback, starting with this:

Ask a loan holder, “All other things equal, would you rather have a cov-lite loan or a normal one?” The answer will always be “Normal, of course. Why are you asking such a dumb question?”

Loan holders would prefer more defaults with lesser severity than fewer with higher severity. What is flexibility to the borrower is a higher degree of expected credit costs to the lenders.

I think both Foley and I would disagree here. All other things equal — including one’s position in the credit cycle — I for one would rather have a cov-lite loan than a normal one. For one thing, as Moody’s discovered, cov-lite loans do not default with higher severity than normal loans; in fact, their recovery rate, even for loans originated in the frothy years of 2005-7, was a whopping 90%. Intuitively, one might expect cov-lite loans to have “a higher degree of expected credit costs to the lenders”. But empirically, that just doesn’t seem to be the case.

More conceptually, if I’m lending to a company, I want it to concentrate on survival, when it gets into trouble, rather than being thrown to financial wolves whose interests are not even aligned with each other, let alone those of the company. Here’s Foley:

Potential covenant breaches excite lenders more for the opportunity they present to take some fees and reprice their loans at a higher interest rate.

And even this is not a straightforward matter. Since leveraged loans are parcelled out and traded on the open market, companies may have to satisfy many, often competing, interests – from fund managers concerned mainly with interest income, to vulture funds who may be playing in a company’s debt in the hopes of pressuring management into merger and acquisition activity. The process is about as far away from a friendly chat with your sympathetic bank manager as it is possible to get.

Such negotiations come at a time when a company’s energies might be better focused on steering the business through a tough patch.

In other words, I can see the attraction of covenants both to banks and to hedge funds who might be looking for the perfect leverage point from which to take over control of a company. But as a passive investor, I’m happier in cov-lite, especially if I have any exposure to the company’s equity.

Merkel then makes a second point, which is slightly stronger. Look at the credit cycle, he says: first debt is an attractive buy, and then yields fall, and then covenants weaken, and then defaults rise and the market crashes, at which point debt is an attractive buy again. If that’s the cycle, then a rise in cov-lite issuance is a clear sign that the debt markets are toppish.

I’m not sure I buy this either. For one thing, actual default rates turned out to be much lower, in the wake of the credit crunch, than the level of defaults that everybody was pricing in and expecting after Lehman Brothers collapsed. And the reason is simple: monetary policy, which loosened up considerably and unleashed a wave of liquidity into the debt markets, allowing troubled companies to refinance. Right now, monetary policy is still loose, and companies have never been more profitable. The combination makes it unlikely that we’ll see a spike in default rates any time soon.

And then there’s the case I was trying to make in my post — that investors have finally realized that cov-lite loans are just as good, if not better than, their covenanted siblings. As a result, the spike in cov-lite issuance isn’t a function of investors giving up protections they’d really rather retain; instead, it’s a function of investors happily giving up protections which in practice only serve to make the borrower’s life more difficult and expensive.

Merkel’s credit cycle makes sense, but it’s not inviolably true. And yes, we’re certainly in the bull-market phase of the credit cycle right now; whenever that happens, a bear-market phase is bound to arise sooner rather than later. Cov-lite loans will get hit in that bear market, along with all other credit instruments. But there’s no particular reason to believe they’ll be hit harder than loans with covenants. In fact, I suspect that, once again, they’ll end up outperforming.


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