Lev Finance Cov Lite article July 2014

Leveraged Finance:
Covenant-Lite Issuance Casts A Cloud
Over Future Default Levels
Primary Credit Analysts:
John W Sweeney, New York (1) 212-438-7154; john.sweeney@standardandpoors.com
Kenneth J Fleming, New York (1) 212-438-1490; kenneth.fleming@standardandpoors.com
David P Wood, New York (1) 212-438-7409; david.wood@standardandpoors.com
David C Tesher, New York (1) 212-438-2618; david.tesher@standardandpoors.com
Table Of Contents
Covenant-Lite Issuance Is Swelling, Especially 'B' Rated Loans
Default And Recovery Data On Covenant-Lite Loans
Covenant-Lite Borrowing Is More Prevalent In Certain Industry Sectors
Than Others
How Standard & Poor's Assesses Covenant-Lite Risk
Positive Market Momentum May Be Veiling Credit Risk--The Surge In 'B'
Rated Loans Is The Major Concern
WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 14, 2014 1
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Leveraged Finance:
Covenant-Lite Issuance Casts A Cloud Over
Future Default Levels
With the current hyper-liquidity in the capital markets, largely due to central bank "cheap-money" policies, and
investors' unquenchable thirst for yield, the issuance of covenant-lite first-lien loans, which lack financial maintenance
covenants, has boomed in 2013 and thus far in 2014. Standard & Poor's Ratings Services is concerned that the sizable
amount of first-lien covenant-lite loans now outstanding, particularly those rated in the 'B' category, along with rapid
growth in traditional 'B' first-lien loan issuance, could result in elevated refinancing risk and/or a spike in defaults in
the event of a future liquidity crisis. (Watch the related CreditMatters TV segment titled, "Booming ‘B’-Rated
Covenant-Lite Issuance Heightens Restructuring And Default Risk," dated July 15, 2014.)
Overview
• There has been a proliferation of covenant-lite corporate loan borrowing in the U.S. over the past 18 months, a
majority of which Standard & Poor's rates in the 'B' category.
• General market stability and positive economic conditions are masking the credit risk associated with 'B' rated
covenant-lite and traditional loans.
• In the event of a significant financial market liquidity crunch, default rates for covenant-lite borrowers could
spike well above the levels seen during the 2008-2009 financial crisis.
Loan refinancing risk currently peaks in the 2017-2019 period (see chart 1). If a liquidity crunch were to occur in any of
these years, banks and investors would become more risk averse as issuer performance and liquidity deteriorates.
Refinancing risk could then amplify for borrowers of maturing loans without financial maintenance covenants, as these
borrowers could become less attractive to a more limited and discerning lender base. Rapid credit erosion could then
occur for companies unable to satisfy their new funding requirements. In our opinion, lenders should not interpret
historical covenant-lite default levels from the last downturn--or currently subdued default rates--as a sign of what the
future holds, and should expect default rates for 'B' rated loans--particularly 'B' rated covenant-lite loans--to increase
during the next downturn.
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Chart 1
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Leveraged Finance: Covenant-Lite Issuance Casts A Cloud Over Future Default Levels

Covenant-Lite Loans Defined
Covenant-lite senior loan transactions do not contain financial maintenance covenants, which stipulate minimum
financial performance measures for the borrower. However, they are not devoid of covenants. Covenant-lite
loans, much like speculative-grade bonds (those rated 'BB+' or lower), typically contain incurrence-based
covenants; for example, a credit agreement may limit a company's ability to incur additional indebtedness. The
agreement may also place restrictions on liens, asset sales, investments, etc. Loan structures that lack
maintenance covenants can potentially hinder a lender's ability to re-price credit risk and reduce a lender's ability
to restructure a problematic loan and mitigate potential losses. They are favored by borrowers because of the
additional financial flexibility they can provide in periods of stress due to their lack of financial metric restrictions.
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Covenant-Lite Issuance Is Swelling, Especially 'B' Rated Loans
Covenant-lite loans that came to market in 2013 reached record levels of $260 billion--up markedly from $97 billion in
2012. According to data compiled by S&P Capital IQ's Leveraged Commentary & Data (LCD), covenant-lite loans
have accounted for 66% of new loan volume for 2014 year to date, compared to 57% in 2013 and 32% in 2012 (see
chart 2).
In the years prior to the credit crunch of 2008, 'B' rated loan issuance outpaced 'BB' issuance on an annual basis.
Beginning in 2008, however, lenders became more discriminating, and the trend reversed. Then in 2012, the trend
came full circle, and 'B' rated lending once again began to dominate the speculative-grade loan market (see chart 3).
Meanwhile, year-to-date 2014 'B' rated covenant-lite issuance has accounted for 58% of total covenant-lite issuance,
compared to only 38% in 2007 (see chart 4).
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Chart 3
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Chart 4
Default And Recovery Data On Covenant-Lite Loans
Our research shows that covenant-lite loans in the 2007-2013 period have fared somewhat better than traditional loans
from a default perspective, but slightly weaker from a recovery viewpoint (see charts 5 and 6). However, there is only
limited data on covenant-lite defaults, and even less data on covenant-lite loan recovery, which makes it very difficult
to draw definitive conclusions. At the peak of the last credit cycle in 2007, covenant-lite lending accounted for only
25% of total loan issuance, with a relatively smaller percentage of these transactions rated in the 'B' category. This
contrasts markedly with 2014, where covenant-lite issuance has accounted for approximately two-thirds of loan
market issuance, with a majority in loans in the 'B' rating category, which, by definition, have higher default
probabilities and refinancing risk than 'BB' rated loans. If the current elevated 2014 'B' rated loan issuance volume run
rate continues through year-end, new loans in this rating category for 2012-2014 will total approximately $694
billion--up about 40% from 'B' rated loan issuance of $501 billion in 2005-2007.
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Covenant-Lite Borrowing Is More Prevalent In Certain Industry Sectors Than
Others
Covenant-lite loans are not evenly distributed across industry sectors (see chart 7). Over the past year and a half,
borrowers in industries such as retail, manufacturing and machinery, and building materials have come to market with
more than 90% of their first-lien loans having no maintenance covenants. For example, in the case of building material
companies, expectations for improving housing and construction markets are driving lenders' willingness to lend under
covenant-lite terms. And borrowers in this sector are reluctant to agree to maintenance covenants in the current credit
cycle because of the problems they encountered with these covenants in the last downturn. In the case of
manufacturing, the perceivably strong collateral coverage that lenders have continued to obtain partially explains the
high level of recent covenant-lite issuance in this sector. On the other hand, less than half of the issuers in the oil and
gas, transportation, and cable industries are utilizing covenant-lite structures.
How Standard & Poor's Assesses Covenant-Lite Risk
Standard & Poor's considers the deterioration in loan covenant protections for creditors as being typical of the
booming, highly liquid debt capital markets, where terms, conditions, and borrowing costs have moved increasingly in
favor of borrowers at the expense of lenders. While we are concerned about the proliferation of 'B' rated covenant-lite
loans for the reasons previously mentioned, we are of the opinion that there are both positives and negatives
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associated with this type of transaction from a credit risk perspective at the individual loan and issuer level. Hence, we
do not view the structure as inherently good or bad.
In our view, the absence of maintenance financial covenants can provide a company with additional financial flexibility
(i.e., liquidity) in times of stress, precluding lenders from having the ability to accelerate a loan via a technical
event-of-default provision. This added liquidity can provide a lifeline for an issuer in a period of stress, ultimately
enabling a company to recover without defaulting or needing to renegotiate terms, conditions, and pricing. That said,
the lack of maintenance covenants can also give aggressive financial management teams and sponsors more latitude
to pursue shareholder-friendly and other actions that may ultimately hurt their credit profiles. Instead of saving a
company, a covenant-lite loan structure, under certain circumstances, could simply delay an inevitable default--and
severely undermine a company's enterprise value along the way, impairing lenders' recovery prospects.
From an analytical perspective, Standard & Poor's considers maintenance covenants in two specific areas of our
corporate and recovery ratings. First, when financial triggers are embedded in a debt structure (i.e., in a "traditional"
non-covenant-lite transaction), our forward looking projection analysis captures these triggers via our liquidity
analysis. Second, the potential for aggressive management from a financial sponsor, which is further increased with
covenant-lite transactions, is an explicit factor we incorporate into our forward-looking speculative-grade corporate
credit ratings.
As part of our recovery analysis, we simulate a hypothetical path to default for the borrower. We assume that
borrowers with maintenance covenants in their loan agreements will trigger these covenants as their financial position
weakens and they approach insolvency. Such a scenario typically results in an amendment/waiver process where the
bank syndicate subsequently demands higher interest margin compensation to offset the greater default risk to which
they are now perceivably exposed. The increase in interest expense implies that a company will default at a slightly
higher level of profitability than it would have otherwise attained (because it will likely default sooner than it would
have minus the maintenance covenants), resulting in less business value deterioration and, thus, relatively greater
recovery prospects for lenders.
In our recovery study published in January 2013 and updated in February of this year (see "Standard & Poor's U.S.
Recovery Rating Performance--A Five Year Study," published Jan. 29, 2013, and "U.S. Recovery Rating Performance
Study: 2007-2013," Feb. 25, 2014), we compared the default and recovery performance of covenant-lite facilities to
those of our entire universe of rated speculative-grade corporate debt. From 2007 through 2013, we found that
covenant-lite loans have slightly lower default rates, but that recovery levels were not quite as robust. When defaults
for covenant-lite loans did ultimately occur, however, enterprise values experienced slightly greater erosion than
secured loans with traditional maintenance covenants, thereby reducing lender recoveries.
Positive Market Momentum May Be Veiling Credit Risk--The Surge In 'B' Rated
Loans Is The Major Concern
Although the absence of maintenance financial covenants can help a company by providing it with additional financial
flexibility, covenant-lite loan structures increase the likelihood that financial managers/sponsors will take aggressive
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actions that could hurt the borrower's credit profile. Standard & Poor's incorporates this risk into its forward-looking
financial policy assessment of sponsor-owned and highly leveraged corporate entities. Further, when defaults do occur,
we'd expect the financials of companies without maintenance covenants to deteriorate somewhat more than those
with traditional financial covenants, which would likely modestly reduce overall debt recovery rates.
Currently favorable economic and market conditions are masking the risks associated with the spate of covenant-lite
and traditional loans--particularly the 'B' rated ones--recently coming to market. It is our view that if a marked liquidity
crisis were to occur, preventing covenant-lite and traditional loan structure borrowers from acquiring new funding, the
default rate for bank loans, as well as the dollar value of defaults, would rise--possibly significantly--from the levels
experienced in 2008-2009.
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Lev Finance Cov Lite article July 2014

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Lev Finance Cov Lite article July 2014