The absence or near absence of financial maintenance covenants in a bank loan agreement will probably affect ultimate recovery values should the loan default, but not to the same degree as other factors, such as the amount of debt that ranks junior to the loan, or the security on the loan, Moody’s Investors Service said in a new report. It is unlikely that such a “covenant lite” credit agreement by itself will lower a rating.
“Two firms identical in all respects except covenants probably have different expected recovery rates in the event of default,” said Moody’s Senior Vice President Russell Solomon.
“The data, however, does not yet show sufficient difference to warrant a difference in companies’ ratings, except at the margin for companies that are otherwise strongly or weakly positioned in a rating category. Nonetheless, Moody’s Loss Given Default rates will often be higher in situations where weak covenant structures are evidenced.”
Moody’s data showed that debt cushion — the amount of debt that is junior to the bank loan — is the single most significant determining factor for ultimate recoveries on the loan. Security, and more specifically the quality of the collateral pledged as security, is also highly relevant but generally to a lesser degree than debt cushion. “In order of magnitude,” said Moody’s Group Managing Director Michael Rowan, adding that “covenants tend to rank a somewhat distant third to debt cushion and security in terms of importance for recovery.”
Moody’s said investors are correct to be concerned that current bank loans, should they default, will show lower recovery values than bank loans have done historically.
“We expect lower average recoveries for loans in the near future because, in contrast to leveraged transactions in the past, loans now often represent a much more significant share of issuers’ consolidated capital structure,” said Daniel Gates, Chief Credit Officer for corporate finance in North America.
“Aside from covenant lite credit agreements, the loan market has increasingly seen larger senior debt tranches, more sharing of collateral between creditor classes, and higher financial leverage trends that have been evidenced not only in North American markets, but in the European marketplace as well,” said Michael West, Group Managing Director for European Corporate Finance. “These trends are in sharp contrast to past practice, and collectively warrant concern that has been reflected in lower ratings,” he added.
In 2006, Moody’s enhanced the transparency of its expected loss-based ratings by introducing Probability of Default Ratings (PDR) and Loss Given Default (LGD) Assessments for corporate issuers. As announced earlier this year, Moody’s will soon adapt its CLO rating methodology to explicitly incorporate the new PDRs and LGD point estimates.
“Covenant-driven considerations that impact CFRs, PDRs and/or LGD rates will be captured in Moody’s ratings for structured finance transactions,” added Bill May, Managing Director of Moody’s CLO team.
