Saturday, February 5, 2011

Covenant-Lite Loans are Back

One would have thought that the meltdown of the leveraged loan market in 2008 would have left a lasting impression on participants in the industry. However, the recent flood of money into the loan market has resulted in a diminution of credit standards comparable to what we saw in late 2006/early 2007. As demonstrated in the chart below, covenant-lite loans have represented 26% of all new loans issued year-to-date in 2011, nearly identical to the 25% level hit in 2007, and more than 5 times the percentage seen in 2010. While the sample size is fairly small ($8.8bn YTD 2011 vs. $100 billion in 2007), hearing the words “covenant-lite” and “PIK-Toggle” enter the lexicon of credit investors scares me tremendously.

With rates and covenants so remarkably favorable to borrowers, it is only a matter of time before the LBO machine begins to ramp up into overdrive. Supply is what broke the back of the last LBO bubble - I have little doubt that it won’t do the same this time.

Over the last year, I have been highlighting the mounting excesses in the credit markets. Admittedly, my fears have not been borne out and credit investors would have been well-served by ignoring my concerns (generally, a pretty lucrative trading strategy:). However, not in my wildest dreams could I have imagined that at this stage in the recovery, we would still be talking about zero percent interest rates “for the foreseeable future.” The Global Food Index just breached its 2008 highs and oil is flirting with $100/barrel and yet our esteemed Fed Chairman sees no evidence of inflation in the economy. How many countries have to endure mass riots over parabolic food rises before Bernanke will abandon his unyielding reliance on the heavily manipulated CPI numbers?

With rates across the entire yield curve kept artificially low, perhaps this can go on for some time. Bernanke’s comments on Thursday talking down any inflationary pressures in the economy have given investors a license to speculate. However, I have no doubt that when the Fed begins to tighten, this mini-reincarnation of the 2007 credit bubble will quickly be snuffed out.

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