July 26, 2018 - Is good news boring (and possibly fleeting)?

The discussion of deteriorating loan covenants has been long-winded, widespread and, perhaps, not unwarranted. Most recently, on Tuesday Moody’s published a report declaring that loan covenant “[p]rotections hit weakest level on record as conditions continue to favor borrowers.” Fair enough. But two more reports should be discussed: First, Covenant Review noted that covenant terms increasingly flexed in favor of lenders in second quarter (and more so in July). Second, lender pushback may have been predicated on technicals favoring the buyside. That might – emphasis on might – be easing.

After improving slightly in fourth quarter 2017, on a scale of 1-5, Moody’s Loan Covenant Quality Indicator (LCQI) hit a record (worst) of 4.12 in first quarter 2018, ThomsonReuters LPC reported. In particular, Moody’s is concerned about borrowers’ ability to manage their capital structure and balance sheet by selling collateral and transferring assets; weak mandatory prepayment provisions may mean that borrowers do not need to repay debt when selling assets. None of this is positive for recoveries.

But there is good news as well. First, Moody’s says that the rate of deterioration has slowed. Second, Covenant Review reported that “Covenant Flex Favors Lenders Again in July”. At a high level, since April 1^st, 45% of first-lien institutional loans saw some sort of covenant flex in favor of lenders; this is up from 35% in first quarter 2018.  A few statistics bear this out. First, on the accordion free-and-clear tranche, 17% of post-April 1^st deals flexed the dollar cap in favor of lenders, while 24% flexed the grower percentage in lenders’ favor. This is up from 6% and 3%, respectively in first quarter.  Lenders also looked to tighten EBITDA addbacks: 32% of deals tightened in the post-April 1^st era, compared to 9% in first quarter. And lenders did not want assets slipping away without loan paydowns: 33% of deals saw asset sale stepdowns dropped, compared to 7% in first quarter.

So, do firmer loan terms stick? We shall see. Investor backbones were stiffened by the large flow of new loans – and thus a more favorable technical environment – in second quarter. But this may potentially be easing somewhat, with implications in both the secondary and the primary. The average bid in the S&P/LSTA Leveraged Loan Index has recovered 30 bps this month, hitting 98.36 as of Wednesday. In turn, LevFinInsights noted that a few opportunistic deals have reappeared in the primary.