11.3.2011

By Simon Miller

Companies with lenient covenant terms are more likely to default - hitting their lenders acording to a report by ratings agency Moody's.

The report said the relatively swift recovery of debt markets following the credit crisis masked the true risk of covenant-lite loans. In a more prolonged credit downturn, companies with lenient covenant terms would be more likely to default, and their lenders would likely recover less than would investors in defaulted companies with more restrictive covenants.

Covenant-lite loans proliferated during the credit bubble, often funding large, private equity-backed buyouts. Despite their widespread use, bubble-era covenant-lite provisions generally did not lead to disastrous losses for investors in the wake of the credit crisis, Moody's said.

"The next downturn in credit markets is unlikely to be as forgiving," said Christina Padgett, senior vice president at Moody's and author of the report. "Investors did not endure the full consequences of covenant-lite loans during the last crisis, due to the swift revival of credit markets and the lower default risk inherent in covenant-lite bank structures."

According to the report, covenant-lite provisions allow companies to avoid default for a longer time, increasing the risk that value will be lost for creditors at default. Bondholders, who typically rely on bank financial maintenance covenants to preserve value, suffer disproportionately when a covenant-lite issuer defaults.

Restrictive maintenance covenants, on the other hand, "limit a company's risk-taking and potential credit deterioration prior to distress or bankruptcy," Padgett said. "This provides protection for the senior secured lenders and the bondholders below them in the capital structure. Historically, high-yield bondholders have been able to rely on these strong bank agreements to constrain aggressive behavior by the issuer or its private equity sponsor."