The good news is that investors will find slightly better protection on leveraged loans this year. The bad news, according to Moody's Investors Service, is that loan covenants will remain categorically weak for a fourth straight year.
“Investors in today's volatile market are being exposed to rising risk as they forfeit key levers traditionally available to them when a borrower is in financial distress,” Moody's analysts lead by Enam Hoque wrote in a March 8 note to clients. Data “indicate that covenant protections remain stubbornly weak.”
Moody's loan covenant quality score, judged according to seven factors including asset sales without lender approval and the use of net debt in calculating leverage ratios, has remained “weak” since 2013.
A drop in issuance in 2016 may allow investors to be more selective and “to receive protections that were not available in the red-hot market of 2013 and 2014,” Moody's analysts wrote.
The latest report comes as banking regulators have been trying for more than two years to curb excessive risk-taking by Wall Street's biggest lenders as they seek to limit their exposure to loans made to heavily indebted companies.
Contributing to the weakness are leveraged loans with little protection known as ” covenant lite,” which typically strip out minimal financial-maintenance requirements such as provisions that limit additional debt a borrower can incur. These reached a record 56 percent share of total issuance last year, even as overall issuance declined, according to data compiled by Bloomberg. The share of covenant-lite loans have dropped to 44 percent this year.
“The continued dominance of covenant-lite loans in the market continues to drag the average score down,” the analysts wrote. “In order for covenant quality to significantly improve, investors must push back and demand better protections.”
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