The covenant quality of North American leveraged loans is close to its worst-ever level as investors forfeit protections they may need if borrowers become distressed, Moody’s Investors Service said Thursday.
The credit-rating agency is the latest to sound the alarm on a market worth about $1.4 trillion that some say is concentrating debt in a way that resembles the subprime lending mania that sparked the 2008 financial crisis.
In July, Moody’s Analytics Chief Economist Mark Zandi said the rise of the leveraged loan market—loans issued by companies that don’t carry investment-grade ratings—is one of the few areas where investors are rightly concerned about excessive debt levels in the U.S. economy. Zandi said an implosion of over-levered firms could provide the spark to halt the second-longest economic expansion.
Moody’s said its Loan Covenant Quality Indicator, a measure of the level of protections for investors embedded in junk-rated leveraged loans issued in the U.S. and Canada, ended the second quarter at 4.09, up from 4.05 at the end of the first quarter.
The LCQI rates quality on a five-point scale where 1.0 is strongest and 5.0 is weakest. It is now just one basis point away from its record worst, recorded in the third quarter of 2017.
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“Investor demand for leveraged loans has soared in 2018, fueled by an appetite for floating-rate instruments, accommodative markets and a low default rate forecast,” Enam Hoque, senior covenant officer at Moody’s, said in a release. “And borrowers continue to capitalize on this demand by negotiating flexible covenant structures, with weakness not limited to ‘cov-lite’ loans, but apparent across all risk categories.”
Covenants are the bells and whistles in loan and bond agreements that protect investors by restricting borrowers from actions such as further borrowing, as a way to ensure they are able to make their interest payments. Cov-lite loans are exactly what they sound like; loans made with less stringent conditions for the borrower.
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Moody’s tracks a total of seven risk categories in assessing protections, all of which are deteriorating. Covenant protections are “dramatically weaker” today than before the last recession, it said.
“Borrowers in today’s market are negotiating bond-like features in their credit agreements,” said Hoque. “Furthermore, today’s credit agreements are characterized by their potential to allow for collateral-stripping asset transfers, the incurrence of large dilutive debt capacity (in the form of incremental equivalent debt) and the retention of asset sale proceeds in ways that do not benefit loan investors.”
The trend is setting the market up for some serious pain in the next economic downturn. Just like subprime loans at the peak of the crisis, leveraged loans have been bundled into instruments called collateralized loan obligations, which offer better returns to yield-hungry investors.
As debt cushions deteriorate, they are dragging down the ratings of debt instruments with them and setting the stage for weaker recoveries in the next downturn.
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Moody’s is forecasting recovery rates of 61 cents on the dollar for first-lien term loans in the next downturn, compared with a historical average recovery rate of 77 cents on the dollar. First-lien term loans sit at the top of the capital structure, meaning those investors should be paid back first in the event of default.
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“Furthermore, private-equity firms’ predisposition for high leverage, aggressive financial policies, and propensity to invest in smaller businesses contribute to a weak rating distribution for portfolio companies that signals high default risk in the next economic downturn,” said the agency.
The riskier credits in Moody’s coverage include loans made to Beacon Roofing Supply Inc. BECN, -1.66% TV broadcaster and magazine advertising company Meredith Corp. MDP, -1.60% Laureate Education Inc. and electrical raceway product maker Atkore International Inc.
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