Moody's: Covenant-lite loans fast becoming new normal in Europe's speculative grade loans markets

Soaring demand for riskier spec-grade loans, a rapidly expanding base of investors hungry for returns and limited new deal flow are allowing borrowers to increasingly issue loans without any financial maintenance covenants, says Moody's Investors Service in a report published today.

This practice will become standard for the remainder of 2017, further eroding protection for investors.

"The rapidly moving trend toward covenant-lite leveraged finance transactions will continue into 2017-18, as persistently low interest rates and low corporate default rates in Europe fuel demand for high-yield debt," says Tanya Savkin, Vice President -- Senior Analyst at Moody's.

Moody's report, "Speculative-grade non-financial corporates -- EMEA: Covenant-lite returns with a vengeance, eroding investor protection," 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.

In the first quarter of 2017, 67% of all term loan B leveraged finance transactions were covenant-lite, up from 48% in 2016 and 27% in 2015. In the remainder of 2017 and 2018, financial maintenance covenants will be used mostly in smaller transactions in more volatile sectors such as retail, which tend to have stronger covenant protection than manufacturing, healthcare and business and consumer services.

"As the market moves towards a covenant-lite model, we expect this trend to become even more distinct, with maintenance covenants only used by a limited selection of issuers to attract investors to smaller transactions dominated by bank lenders," adds Ms Savkin.

The more diversified investor base for big syndicated loans is willing to accept covenant-lite terms because of greater liquidity in the secondary market offered by larger deals and competition from high-yield bond structures.

Headroom under maintenance covenants will continue to increase, eroding investor protection and moving in favour of borrowers. The proportion of the transactions with less than 30% headroom on the closing date fell to 30% between 2015 and Q1 2017 from 42% in 2013-14. Of those transactions between 2015 and Q1 2017 with maintenance covenants, 15% were particularly aggressive, with more than 40% headroom.

Moody's expects covenant headroom to continue to increase, but at a slow pace. Where maintenance covenants are still present the headroom will probably range between 30%-40% providing an element of control to lenders in the event of a borrower's material underperformance.

The guarantor coverage test will remain widely included in loans issued, but has shifted to a single EBITDA test from both EBITDA and assets tests. However, the required coverage has stayed at 80% of EBITDA for most term loan B loan transactions. The rating agency expects a guarantor coverage test of 80% EBITDA to remain an important feature of leveraged loan transactions.