Credit markets have changed significantly since the Great Financial Crisis (GFC). One major adjustment has been the use of covenants to protect lenders and bind the behavior of borrowers. In the last crisis, cov-lite loans were less than 5 percent of the total. Now, cov-lite is well over 85 percent of the total institutional loans.
We have not had a recession, financial crisis, or a credit downturn since this structural change has taken place. We have no history with what will happen in a cov-lite environment. Loans with limited covenants cannot serve as potential tripwires for credit deterioration. A new paper provides some useful information on what may be possible. See "Consequences of Cov-lite Loans" by Demerjian, Horne, and Moon.Their work shows how much the market has changed over the last decade.
Determining the impact of changes in loan covenants is not an easy topic to research. There are a number of conflicting theories associated with agency problems between lender and borrower. A breach of a covenant is a technical default that can be addressed before there is a default.
The main concern is that there will be more risk to lenders given there is a decline in monitoring of the borrower. The cov-lite trend has been a part of the movement to have more standardized loan features to make them easier to securitize into CLO's. Loans with more and varying covenants will be harder to bundle.
The authors find that cov-lite loans are more likely to default than loans that have more covenants, and these loans take longer to default because there are no intermediate signals of financial difficulties that will trigger action, all else equal. The end result is that cov-lite loan contracts will have a higher financial costs.
If we look at the current environment, there should be strong credit concerns. In a covenant heavy loan, there will be accounting triggers that will send signals to lenders on impending liquidity issues and signals to borrowers to make income-increasing decisions to avoid technical default. If a technical default is reached, lenders can then take action to force a change in borrow behavior, or engage in activities to protect their loan from further loss.
Firms that have liquidity shortfalls against covenant terms will require restructuring. In a cov-lite environment, action can be delayed, but with consequence of further loss for the lender. A problem deferred is not a problem eliminated. We may think there will be an overall loan problem because loan terms are more lenient versus the last financial crisis.
We have not had a recession, financial crisis, or a credit downturn since this structural change has taken place. We have no history with what will happen in a cov-lite environment. Loans with limited covenants cannot serve as potential tripwires for credit deterioration. A new paper provides some useful information on what may be possible. See "Consequences of Cov-lite Loans" by Demerjian, Horne, and Moon.Their work shows how much the market has changed over the last decade.
The main concern is that there will be more risk to lenders given there is a decline in monitoring of the borrower. The cov-lite trend has been a part of the movement to have more standardized loan features to make them easier to securitize into CLO's. Loans with more and varying covenants will be harder to bundle.
The authors find that cov-lite loans are more likely to default than loans that have more covenants, and these loans take longer to default because there are no intermediate signals of financial difficulties that will trigger action, all else equal. The end result is that cov-lite loan contracts will have a higher financial costs.
If we look at the current environment, there should be strong credit concerns. In a covenant heavy loan, there will be accounting triggers that will send signals to lenders on impending liquidity issues and signals to borrowers to make income-increasing decisions to avoid technical default. If a technical default is reached, lenders can then take action to force a change in borrow behavior, or engage in activities to protect their loan from further loss.
Firms that have liquidity shortfalls against covenant terms will require restructuring. In a cov-lite environment, action can be delayed, but with consequence of further loss for the lender. A problem deferred is not a problem eliminated. We may think there will be an overall loan problem because loan terms are more lenient versus the last financial crisis.
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