We've Seen This Movie Before - The Return of Covenant Lite and ...


Even as the financial crisis of 2008-09 began to ebb, the so-called “wall of debt” loomed large. Hundreds of billions of dollars of leveraged and high yield debt issued during the irrational exuberance era was coming due by 2014, threatening to drive up default rates and posing an ongoing threat to the health of the international financial markets. 

Those fears seem very distant today. First, the “wall” got pushed back, as lenders and debt investors engaged in an ongoing game of what came to be colloquially referred to as “amend, extend and pretend”, renegotiating maturity dates in an effort to delay the day of reckoning. Now, thanks in no small part to central bankers’ determination to keep interest rates as low as possible, a white-hot high yield debt market has broken the wall into pieces, with parts of it not to be reassembled for decades. High yield (aka “junk”) debt issuances have returned to levels not seen since 2007, and are allowing leveraged companies to refinance pending obligations with maturities in some instances of as long as 30 years

Incredibly, the demand for lower quality / higher yielding debt securities in the current low interest rate environment is already leading to the return of two features that embody some of the worst excesses of the previous decade. S&P and Moody’s have both recently warned about “covenant lite” debt, i.e., issuances that lack standard covenant protections which serve as early warning signs and permit lenders and investors to intervene at an early stage of a borrower’s financial distress. Other commentators are taking note of the return of another feature that led to deep investor losses during the last downturn – notes with payment in kind, or “PIK” features, which permit a borrower to flip an invisible toggle and switch from paying interest in cash, and instead allow it to effect payment through the issuance of additional notes.      

There is nothing inherently wrong with extending credit to lower rated borrowers. But lenders and investors astoundingly seem already to have forgotten that, along with the higher yields that compensate them for the incrementally greater risks they are taking by lending to such borrowers, such credits require stronger, not weaker protections against defaults. The constantly repeated excuse last time was that no one could have seen what was coming. What will it be next time?