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Cov-Lite Train Wreck Ahead?

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Cov lite Loans—loans without the usual protective covenants to safeguard lenders—are making a major comeback. Ominously, this uptick in cov-lite loan issuance coincides with a Moody's research note, which I wrote about on Friday, that suggests grim prospects ahead for future defaults in cov-lite.

Specifically, the Moody's report suggests that weakened or non-existent loan covenants mean not just a greater probability of loan defaults— but ultimately a lower percentage of recovery for the creditors. Taken in concert with the massive growth in this type of loan, it seems reasonable to wonder aloud about the fragility of the credit markets in respect to these loans.

Begin with this: The jump in cov-lite loans this year has been explosive.

Nicole Bullock at FT's Alphaville is reporting that this year a staggering $30 billion in cov-lite loans have already been issued. That figure represents year-to-date issuance—not an annualized projection for 2011 based on current trends.

At that pace, 2011 is on track to eclipse the nearly $100 billion issuance of cov-lite loans in 2007—which took place at the height of the credit bubble.

What's more, as a total percentage of syndicated loans issued, cov-lites have actually slightly increased from the bubble years—from 25 percent issued in 2007 to just over 27 percent in 2011.

(By way of contrast, in 2010 lenders issued a total of $8 billion in covenant lite loans, which represented just over 5 percent of all new syndicated loan issuance.)

Why is all of this so potentially problematic?

As Christina Padgett, the lead author of the Moody's report I mentioned earlier explains:

"Covenant-lite provisions allow companies to avoid default for a longer time, increasing the risk that value will be lost for creditors at default. In the absence of maintenance covenants measured at regular intervals, which allow lenders to keep a tighter rein on a company's financial risk-taking, issuers have more means of avoiding default. For investors in covenant-lite capital structures that ultimately default, the extra time can lead to lower recoveries."

As I wrote on Friday: "In other words the damage done by cov-lite loans is two-fold: First it makes default more likely —by simply allowing fewer restrictions on the borrower's risky activity. Second—and far more insidious—it masks the underlying warning signs that a loan is about to bust—and causes an even uglier work out for the creditors in the long run."

In another interesting wrinkle in the Alphaville story, the author points to the current resurgence of PIK toggle notes associated with new lending.

She explains "Pik toggle notes give the company the option, in a squeeze, to pay lenders with more debt, rather than cash."

A more cynical interpretation might be that PIK toggle notes allow companies the option to pay out more worthless paper instead of cash—all the while burning through more assets—resulting in a lower recovery rate for their creditors.

The Alphaville article ends by stating that "Defenders of cov-lite loans say they prevent investor losses by allowing stretched borrowers to survive without defaulting."

This is precisely the point that Moody's Christina Padgett is making—which, from the perspective of the creditors, may be a disastrous idea.

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