Moody's: Covenant-loose to remain the norm in 2016 for European leveraged loans

Loose covenant protection for European leveraged loans will likely remain the market norm through 2016, says Moody's Investors Service in a report published today. 

Moody's report, entitled "Covenant-loose to remain the norm in 2016 for European Leveraged Loans," is available on www.moodys.com. Moody's subscribers can access this report via the link provided at the end of this press release. The rating agency's report is an update to the markets and does not constitute a rating action. 

"Except for some larger, more liquid transactions which will probably remain covenant-lite, we expect market volatility will persist into 2016, which should give investors an opportunity to retain covenant-loose protection," says Martin Chamberlain, a VP-Senior Analyst at Moody's. 

In our report, Moody's describes the term covenant-loose to mean the inclusion of one or two financial maintenance covenants in the term loan documentation. 

Covenant-loose loan documentation remained dominant in 2015, says Moody's, due to a reduction in volumes of high-yield bond transactions amid an environment of investor uncertainty, surrounding the timing and extent of interest rate rises in the US, slowing economic growth in China and unsettled equity markets. 

In 2015, more than half of all speculative-grade bullet repayment loans were covenant-loose versus 43% in 2014 and 17% in 2013, the majority of which incorporated only a net debt/EBITDA financial maintenance covenant. 

Moody's research shows that loan maintenance covenant protections do not necessarily reflect borrowers' underlying credit risk when analyzing term loans in the single B-rating category. However, covenant protections are more closely correlated to loan size and tend to be weaker for larger loans, a trend Moody's expects to continue next year. 

Weakening maintenance covenant protections are being accompanied by more issuer-friendly loan documentation in other areas. "Restrictions permitting borrowers to incur more debt and the amount of debt that can be incurred have moved in favour of issuers. This could lead to credit weakness, or even potential rating downgrades, if borrowers were to take material advantage of such facilities," says Mr. Chamberlain. 

Term loans are increasingly of interest to investors in non-traditional lending markets, particularly hedge funds, institutional investors and credit funds, who have shown a willingness to accept weaker covenant protections, replicating those seen in products such as high-yield bonds and US term loans 

However, Moody's expects that capacity to incur additional debt will remain much lower in loan documentation than high-yield bond documentation. The average capacity to incur additional debt was 0.5x of EBITDA in 2015 for term loan B transactions, compared with 4.2x of EBITDA for high-yield bonds.