Leveraged-Loan Investors Let Companies Take the Wheel

(Bloomberg Opinion) -- Last week, Moody’s Investors Service published its quarterly report on covenant quality in leveraged loans. As usual, it painted a grim picture, with deals in the final three months of 2019 offering the worst investor protections ever seen.

Its release has traditionally been yet another opportunity for market observers (myself included) to shake their heads at overeager investors so desperate for yield that they’re willing to give up typical safeguards. “If and when the credit cycle turns and the losses mount, they’ll have no one to blame but themselves,” I wrote on Jan. 24. “There’s no going back now: The risky debt markets are full of cov-lite deals. Investors either have to acclimate to that reality or get out of high-yield and leveraged loans,” I noted on Feb. 18, a week before markets began an epic free fall.

Obviously, we’re well past the point of scolding now. Since late February, leveraged-loan prices tumbled from 97 cents on the dollar to as little as 76 cents. While they’ve recovered to 86 cents, loan mutual funds are still hemorrhaging cash and credit-rating companies are still downgrading swaths of companies that might not survive the coronavirus pandemic and economic shutdown. That, in turn, is starting to send shockwaves through the $700 billion collateralized loan obligation market, where a growing share of investors in the riskiest equity portions are seeing payments cut off to protect those in the structure’s top-rated tranches, which famously never defaulted during the last recession. The feeling of a cascading effect is palpable.

As of now, the Federal Reserve has shown little appetite to forcefully intervene in this risky debt market. Yes, the central bank expanded its Term Asset-Backed Securities Loan Facility last month to include top-rated tranches of new CLOs. And it’s true that the recent widening of its lending facility for small and medium-size businesses would theoretically reach more distressed borrowers. However, some analysts have speculated that companies might be better off just defaulting and seeking bankruptcy protection now rather than kick the proverbial can down the road on their debt and deal with the facility’s limitations on certain corporate actions.

Creditors might not be so keen on such a strategy. But it looks as if they won’t have as much say as in the past — one of the lasting consequences of eroding covenant quality. It suggests that if a wave of defaults and downgrades is averted, it’ll have to come first and foremost from C-suite decisions rather than from investors looking to maximize returns.

“Having looser covenants takes that seat at the table away and lets the company manage its way through its distress,” Evan Friedman, head of covenant research at Moody’s, said in an interview. “That’s really what has been happening over the past decade with low default rates, more money coming in and a mandate to put that money to work — investors have forfeited that seat at the table and put more faith in the ability of these companies to manage their distress.”

It’s still early days in the Covid-19 shakeout, but struggling companies are starting to pile up. In an April 22 report, Fitch Ratings cited Intelsat Investments, JC Penney Co. and Ultra Resources as just a few companies on their “Top Loans of Concern” list that missed interest payments while also accurately predicting that Neiman Marcus Group would default. Throughout corporate America, 71 U.S. companies with liabilities of more than $50 million have filed for bankruptcy already this year. That includes 19 in April, such as Cinemex Holdings USA Inc., Diamond Offshore Drilling Inc. and Frontier Communications Corp. J. Crew, which has become almost a verb in finance after the company put its brand name and other intellectual property into an entity beyond the reach of its existing lenders, also filed for bankruptcy.

Covenant Review, a credit research firm, heralded the “return of the J. Crew Blocker” in a recent loan deal from Gap Inc. But the risk of a company “pulling a J. Crew” is just one of many worries in a market saturated with weak safeguards. “Top concerns for investors during these turbulent market conditions: the pursuit of distressed exchanges, the shifting of valuable collateral outside the control of creditors, and revolving lenders gaining an upper hand over institutional term lenders,” according to Moody’s.

Yet the most troubling trend this time around, which the credit-rating firm has highlighted for years, is that a growing share of the market consists of companies that only ever borrowed with loans, rather than also issuing unsecured bonds. Leveraged loans usually fare quite well in a restructuring, recovering 77 cents on the dollar on average. But first-lien cov-lite loan debt cushions fell by almost half since 2010, to 17.9% from 33.2%, which is why Moody’s now sees 60% as a more likely recovery rate.

“Leveraged loans did well in the last downturn in part just because there was a lot of junior capital on the balance sheet and they were often senior unsecured and senior subordinated bonds,” Christina Padgett, head of leveraged finance at Moody’s, said in an interview. “We haven’t seen a real history of distressed exchanges within bank-loan-only structures, but we expect that to be the case.”

It’s hard to see what breaks this downward spiral. Among the alphabet soup of outlooks, some have contemplated a K-shaped path forward, with certain companies and segments of the economy bouncing back quickly while others crumble. As each day goes by with heavily indebted firms shuttered, leveraged loans look as if they’ll be part of the lower leg.

Padgett noted that finding a way to push out a restructuring beyond the depths of a economic downturn could benefit both lenders and creditors: Investors get a better recovery rate, while companies receive a higher valuation. Meanwhile, private-equity firms are often able to come up with ways to keep a company viable, she said.

There are certainly stories like this in the market. Bloomberg News recently singled out Surgery Partners Inc., a sprawling network of outpatient clinics that’s majority-owned by Bain Capital. It received a $120 million lifeline from investors in mid-April even though its outstanding loan signaled expectations for default in late March. “It all has worked out so fortuitously for the creditors and equity holders of Surgery Partners,” the reporters noted.

This seems unlikely to be the norm. Just because April marked a banner month for risky debt doesn’t mean leveraged loans will return to their glory days. Creditors will surely be more vigilant — maybe they’ll keep an operator of surgical facilities afloat, but will be less inclined to hand over money to fledgling retailers or energy companies. Add to that the proliferation of cov-lite deals, and investors have little choice but to let companies take the wheel. For now, they’re just along for the ride.

(Updates seventh paragraph to reflect that J. Crew filed for bankruptcy.)

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

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