The percentage of leveraged loans with weak or the weakest covenant protections has reached its highest level since the Great Recession, according to a report from Moody’s Investors Service.
Last year, federal regulators warned that while leveraged lending declined during the financial crisis, volumes had since increased and prudent underwriting practices had deteriorated. For example, they noted, “some debt agreements have included features that weaken lender protection by excluding meaningful maintenance covenants and including other features that can limit lenders’ recourse in the event of weakened borrower performance.”
The new analysis from Moody’s, first reported by Bloomberg on Monday, suggests that warning may be going somewhat unheeded. It found that 65% of debt in the first half of this year had weak or the weakest covenants — up from 60 percent in 2013 and 42 percent in 2012.
The ratings service assigns debt-covenant scores of between one and five, with a one indicating strong protections for investors and a five the weakest. The average loan score at the end of the second quarter of 2013 increased to 3.81 from 3.59 in the previous quarter, according to the report.
“Lenders are being exposed to rising risk as they forfeit key levers they have traditionally been able to pull when a company is starting to experience financial distress,” Moody’s analysts wrote.
In issuing updated leveraged lending guidance in March 2013, the Federal Reserve Board, the Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency said that “Weak initial underwriting of transactions, coupled with poor structure and limited covenants, may make problem credit discussions and eventual restructurings more difficult for an institution as well as result in less favorable outcomes.”
Another report released Tuesday by Moody’s found that bond-covenant quality has also deteriorated, with the average score for a North American high-yield credit rising to 4.14 in the first six months of the year, compared to 3.79 between 2011 and 2013, reported Bloomberg.