With a change in the senior loan market cycle gradually materializing, we feel it is paramount for investors not to oversimplify current market complexities by indulging recent media reports vilifying the borrower-friendly deals issued in recent years. While today’s senior loan default rate remains below the long-term average of 2.9%, softer earnings reported over recent quarters and emerging idiosyncratic risks in certain sectors simply mean that managers will need to be vigilant in their due diligence of the things that are most important to the performance of below-investment grade credit.
We believe that documentation, including covenant-lite features, is but one of several issues that a senior loan manager must consider in a due diligence framework. However, it is certainly not more important than consideration of a company’s leverage levels, balance sheet strength, free cash flow, business value proposition, collateral, or even its management team. In fact, we would prioritize those considerations above both documentation and other often-discussed factors in the media, such as loan-only capital structures, in the consideration of both the default probability and recovery estimation of a borrower.
Too many mouse traps
Not only have covenant-lite loans long been a material element of the market, they are a byproduct of the strong demand and improved trading liquidity fostered during the slow recovery from the Financial Crisis. Furthermore, nearly all of these loans reside at the senior-most position in a borrower’s capital structure, therefore benefiting from a legal pledge of their assets.
The presence - or absence - of covenants is not an indicator of the credit worthiness of a given issuer. In fact, loans with too many covenants could be at greater risk of default during a financial crisis or recession. If lending terms are overly restrictive, otherwise creditworthy borrowers may inadvertently trigger an “Event of Default” as corporate management teams work to manage through the challenging times. With that said, we are not suggesting that cov-lite is uniformly positive. Indeed, as lenders we naturally look for stronger terms and stronger protections (covenants), all things being equal. The primary give-up for a manager, however, is that cov-lite structures can hinder senior lenders’ ability to reprice debt if a covenant is tripped. Most importantly, as noted, the value of a maintenance covenant should never be confused with the protection that comes from having a pledge on the issuer’s collateral. This is perhaps the most significant point lost in the headline noise regarding covenants. As an asset class, senior loans have been historically attractive because of their better risk-adjusted returns, which stem primarily from loans’ higher recovery rates and defaults versus unsecured bonds. Accordingly, assessing the likelihood of loss remains the most important component of underwriting senior loan investment opportunities. While covenant review is certainly an important component of the evaluation process, it is by no means the most important characteristic that investors need to consider.
What really matters: Covenants are just one input on the path to understanding recoveries
On the whole, we think most market participants agree that recoveries in the next cycle are likely to be more challenged. Moody’s Investor Services recently predicted lower recovery rates relative to the asset class historical average of 80% over the next cycle.
In addition to borrower-friendly documentation (e.g. “cov-lite”), projections for lower recoveries stem from the increased prevalence of loan-only structures, i.e. capital structures that do not have a junior debt cushion.
Voya’s view on loan-only structures
We agree that the decline in high yield bond issuance will likely have some impact on recoveries for the loan market in the next cycle; that prognosis is based on simple math. But we’re certainly not resigned to the fact that the downside will apply universally across the market, as every future restructuring case will involve a unique set of factors.
Similar to our view on covenant-lite, we still believe there is no substitute for fundamental credit analysis and the impact of this change will be highly borrower specific. We also believe a diminished cushion must be viewed in the context of collateral valuation at the time of restructuring. Assuming overall distressed company valuations do not deviate materially from historical averages, there is no irrefutable support to argue for materially lower absolute results across the market. In fact, to the extent we had the choice between a simple capital structure with no debt cushion but sustainably valuable collateral versus a highly complicated capital structure with complex legal language permitting shades of grey with respect to senior lender access to such collateral, we may – all else being equal – prefer the first.
The path forward
Ultimately, it is important to remember that covenant-lite, loan-only structures, and more permissive credit agreement terms are the by-products of low global interest rates, and investor demand for yield and improved liquidity. They are the natural and expected result of that shift in the technicals for the loan asset class creating a more borrower-friendly market. However, empirical evidence suggests that the shift has improved the transactional liquidity profile of the loan market (that is, the ability to trade at close to a desired price) as compared to pre-Global Financial Crisis. We generally believe that liquidity is the better tool to manage risk as compared to even covenants or capital cushions. In most cases, we would rather have the ability to trade on our credit views and generate timely liquidity for investors than have stronger maintenance covenants or more traditional bond cushions with limited to no ability to execute a trade. Further, we do believe that even if recoveries for senior loans are something lower than they have been historically, loans will still face a better recovery scenario than unsecured debt.
While there is no simple answer to the risks related to these market trends, we do remain confident that investing in the right companies with good cash coverage, healthy business models, and good management is the best way to mitigate the impact of such risks in a portfolio.
This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) changes in laws and regulations and (4) changes in the policies of governments and/or regulatory authorities. The opinions, views and information expressed in this commentary regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Fund holdings are fluid and are subject to daily change based on market conditions and other factors.
Past performance is no guarantee of future results.