Covenant-lite CLOs: From sub-prime to the ridiculous

Thus, with no pesky covenant triggers to breach, these assets can sit in the CLO without causing any disruption, even if the performance of the borrower seriously deteriorates. And remember – this is a good thing.

This view is admittedly the exception rather than the rule among CLO managers – most of whom express a growing discomfort with the covenant-lite loan phenomenon. But even if they don’t like them they are still buying them – in vast quantities. The percentage of covenant-lite loans in the US market has shot from barely more than zero in 2005 to 40% today. According to Deutsche Bank, covenant-lite issuance in the first quarter of 2007 hit $48 billion – nearly double the level of total covenant-lite issuance during the whole of 2006. And the trend is embedding in Europe as well, as the World Directories, Trader Media and potentially Alliance Boots deals all show.

With the impact of deteriorating asset performance on the ABS CDO market still fresh in everyone’s minds, how concerned should the CLO market be that history could repeat itself in this sector – and soon? "When considering if the CLO market could follow the trajectory of the ABS CDO market due to weaker collateral, the answer has to be yes," admits Sara Halbard, head of European CDOs at fund manager International Capital Group in London. "It is just a question of timing."

Maybe the simplest definition of a covenant-lite loan is – a bond. To all intents and purposes the two are the same, bar the fact that the leveraged loan is collateralized by security. The whole concept of covenant-lite documentation grew from the idea that loan covenants would mirror the kind of covenants that were applied to the bonds underlying them in the LBO capital structure. This means that the loans have just incurrence covenants rather than the traditional maintenance covenant package.

Incurrence covenants merely require that any action taken by the company must not result in it breaching its loan covenants. But if covenants are breached in the normal course of business, for example through earnings deterioration, the trigger is not tripped. Maintenance covenants require an issuer to meet certain financial tests each quarter, regardless of whether any such action (such as a dividend payment, acquisition or fundraising) had taken place. It is not hard to fathom why financial sponsors have leapt at the opportunity to issue covenant-lite debt. What is hard to fathom is how willing the market has been to swallow it.

The covenant-lite phenomenon grew out of its application to certain deals where leverage was low. People thought that as long as there was a pricing premium then the lack of maintenance covenants was a reasonable trade-off. This clearly made sense – the low-documentation loans would be limited to high-quality, large sponsors with low leverage, and lenders would be paid a premium for this additional risk. They are also a product of the convergence of not only the European and US markets but the convergence of the leveraged loan and high-yield capital markets. "High-yield investors moved into the loan product looking for senior secured floating-rate assets," explains Hamish Buckland, co-head of leveraged finance at JPMorgan. "Covenant-lite leveraged loans were very attractive to them." And as high-yield buyers are used to not having any covenants, the "lite" documentation did not present a problem.

But the situation of cov-lite documentation being used judiciously for a select number of high-quality candidates is long gone in the US. Originally designed as an exclusive range purely for the elite, cov-lites are now commonplace. "The number and size at which covenant lites are being rolled out is not judicious," says Mark Okada, chief investment officer at Highland Capital Management in Dallas, Texas. According to Standard & Poor’s Leveraged Commentary and Data, covenant-lite loans now account for between 30% and 40% of the entire US leveraged loan market. Mats Carlston, head of global finance at law firm Nixon Peabody, reckons: "The percentage of covenant-lite loans in the market is growing, and the trend is also moving down to the mid-market." This is having a profound effect on capital structures as (increasingly covenant-lite) term loan Bs and Cs come to represent larger and larger percentages of overall deals with bank-dominated revolvers and term loan As accounting for less and less of the overall package. It is not hard to see why; why should a borrower pay fees for an undrawn facility when it is so easy and cheap to simply borrow as and when required?

Not only is selective application of covenant-lite documentation a distant memory – any pricing premium is too. In early May, US first-lien leveraged loans were pricing at 218 basis points at the B+/B1 level, while covenant-lite loans with the same rating were actually pricing tighter at 214bp. This seems completely nonsensical but is explained away by the fact that cov-lite issuers are generally still of higher quality. But B+/B1 is B+/B1, isn’t it? This trend holds true for all double-B rated US leveraged loans where covenant-lite loans are pricing at 224bp and standard (or as they are now inevitably dubbed "covenant-heavy") deals come in wider at 243bp.

Recent examples of the impact that the covenant-lite documentation is having on the loan market include the deal for mid-market US speciality paper producer Domtar. The firm came to the market with a $1.55 billion facility that involves a $750 million revolver and a $800 million covenant-lite term loan B arranged by JPMorgan. Early price talk for the latter – which is double-B rated – was 175bp but this was subsequently flexed down to 150bp and closed at 137.5bp, an astonishing spread for such a rating with essentially no covenants. Another deal in the market as Euromoney went to press was a $2.4 billion refinancing for Michael’s Stores, the Texas-based US retailer. The original buyout financing in the fourth quarter of 2006 was done at 275bp for the B2/B– rated credit but the borrower has returned looking to refinance the deal at 225bp with a step-down to 200bp in a covenant lite deal arranged by Deutsche Bank.