Fitch: Loose lending terms point to credit top, recoveries to suffer in downturn

  • 80 pct of U.S. institutional loans now covenant-lite
  • Low rates, refinancings, loose terms to postpone defaults
  • Recovery value to lenders likely to be less than in past cycles

Fitch Ratings is calling the peak in credit, citing a slackening of lending terms and a risk-reward mismatch for investors.

The agency reported Tuesday that “significant loosening of underwriting standards points to the U.S. leveraged debt market being in the later stages of the credit cycle.” Fitch mentioned underwriting terms concerning pricing, leverage and documentation language, which typically erode during late stages of credit expansion.

Almost 80 percent of all U.S. institutional loan issuance is now covenant lite, which Fitch defines as the absence of financial maintenance covenants, compared to 25 percent at the top of the cycle in 2007.

Fitch corporates director Lyuba Petrova said the biggest factor in the growth of cov-lite loans is probably “just the passing of time.” Whereas “in 2007, 2008, they were still relatively young,” Petrova explained, “they really are the market standard for institutional loan issuance today.”

Investors’ appetite for leveraged loans, not matched by adequate supply, has led to issuer-friendly terms, including “documentation allowing a borrower to incur additional leverage leading to credit profile deterioration, deterioration of collateral protections, reduced pricing protection” and terms that affect lenders’ ability to transfer debt positions, Fitch’s report states.

While the hunt for yield amid record low interest rates has been driving that demand, the prospect of hikes by the Federal Reserve plays a role as well: the fact that leveraged loans are mostly floating-rate instruments makes them an attractive hedge against rate increases.

“The issuers basically have control,” said Fitch Senior Director John Kempf. “They can push these covenants knowing there’s just so much demand for leveraged-loan paper.”

The resulting flexibility, as well as low coupons and a raft of refinancings since 2016, should allow borrowers to extend the period before default, when the downturn comes. But recoveries will suffer as secured lenders find themselves hamstrung by aggressive terms, and the value of collateral packages is diluted by the issuance of additional debt.

“We haven’t seen how these new terms have played out in downturns before, because a lot of this is new language, new technology,” Petrova said. “It will be very interesting to see how it will impact recovery.”

Action Item: Check out Fitch’s report here:

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