Always consider hidden risks
US Credit Markets: My US Lite Rita Covenant: Freshness without Protection ?
July 31 ( From IMF,, Learn ,  Wiki ​ )​
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The Situation

First Warning Sign From Bernanke

​In a speech in Chicago on May 10 2013,, the US Federal Reserve chairman said he was watching for signs that banks were resorting to speculation because of low interest rates, highlighting the danger that easy monetary policy could inflate new bubbles in asset prices.

His comments show how low interest rates have come to dominate global financial markets as waves of monetary easing send investors scurrying around the world for anywhere they can earn a return on their cash. The average yield on lowly rated corporate debt, or junk bonds, this week dipped below 5 per cent to a record low that is less than US treasury bonds yielded in 2007.


 Staff expressed concern that a faster- and larger-than-expected rise in interest rates could expose vulnerabilities
currently masked by low rates and excess liquidity, with reduced secondary market liquidity potentially exaggerating dislocations.

Authorities acknowledged these risks, which were stressed in the annual report of the Financial Stability Oversight Council (FSOC) and speeches by FOMC members, and noted that regulators have issued guidance against excessive risk-taking. At the same time, investors in these instruments tend to be unlevered, reducing the potential for fire sales triggering negative feedback loops, and corporate bond valuations are not tight relative to historical levels.

​​As cash-rich institutional investors continue to flock to the leveraged loan asset class, issuer-friendly covenant-lite deals comprise an ever-growing share of loan outstandings, which now tops 35%, according to LCD, an S&P Capital IQ unit.

Covenant-lite Loans - A Definition

​​Covenant-lite (cov-lite) loans are loans in which borrowers are not obligated to meet quarterly maintenance criteria.

​​Cov-lite lending is seen as more risky because it removes the early warning signs lenders would otherwise receive through traditional covenants. Against this, it has been countered that cov-lite loans simply reflected changes in bargaining power between borrowers and lenders, and followed from the increased sophistication in the loans market where risk is quickly dispersed through syndication or credit derivatives.

For instance, one covenant may require the borrower to maintain its existing fiscal-year end. Another may prohibit it from taking on new debt. Most agreements have financial compliance covenants, stipulating perhaps that a borrower must maintain a prescribed level of performance, which, if not maintained, gives banks the right to terminate the agreement or push the borrower into default.

The size of the covenant package increases in proportion to a borrower’s financial risk. Agreements to investment-grade companies are usually thin and simple. Agreements to leveraged borrowers are more restrictive.

​​​ ​Ben Bernanke warned against excessive risk-taking in financial markets then as the dollar was driven up in the latest manifestation of a desperate global hunt for yield

​​​​​​​​“Not surprisingly, we try to identify unusual patterns in valuations, such as historically high or low ratios of prices to earnings in equity markets. We use a variety of models and methods; for example, we use empirical models of default risk and risk premiums to analyze credit spreads in corporate bond markets. These assessments are complemented by other information, including measures of volumes, liquidity, and market functioning, as well as intelligence gleaned from market participants and outside analysts.

​​In light of the current low interest rate environment, we are watching particularly closely for instances of "reaching for yield" and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals. It is worth emphasizing that looking for historically unusual patterns or relationships in asset prices can be useful even if you believe that asset markets are generally efficient in setting prices. For the purpose of safeguarding financial stability, we are less concerned about whether a given asset price is justified in some average sense than in the possibility of a sharp move. Asset prices that are far from historically normal levels would seem to be more susceptible to such destabilizing moves. ​​“

​​​“The second motivation for more intensive monitoring is the apparent tendency for financial market participants to take greater risks when macro conditions are relatively stable. Indeed, it may be that prolonged economic stability is a double-edged sword. To be sure, a favorable overall environment reduces credit risk and strengthens balance sheets, all else being equal, but it could also reduce the incentives for market participants to take reasonable precautions, which may lead in turn to a buildup of financial vulnerabilities. Probably our best defense against complacency during extended periods of calm is careful monitoring for signs of emerging vulnerabilities and, where appropriate, the development of macroprudential and other policy tools that can be used to address them.​​“

​​Monitoring the Financial System
​Chairman Ben S. Bernanke
At the 49th Annual Conference on Bank Structure and Competition sponsored by the Federal Reserve Bank of Chicago, Chicago, Illinois
May 10, 2013
The Rising Lite Market Share
( From IMF )​

​​In regard to the nonbank financial sector, staff raised concerns about potential risks arising in a low interest rate and low volatility environment:

​​Excessively loose conditions in corporate credit markets. Authorities agreed with staff that a prolonged period of low interest rates could have adverse side effects in corporate credit markets.

​​Already, there is evidence of weaker loan standards, rising balance sheet leverage,
reduced protection from covenants, weaker quality of new issuances of corporate bonds and, in some cases, less discriminate pricing of
corporate loans.
It’s no wonder cov-lite outstandings are piling up. Year to date, 56% of new -issue leveraged loans have been covenant-lite. That’s up from roughly 20% at this time a year ago and from negligible numbers during the dark days of the 2008-2010.

Cov-lite loans are more appealing to issuers in that include only less-restrictive, bond-like incurrence covenants, which require an issuer to be in compliance with the loan terms only if the issuer takes a specific action (making an acquisition, for instance). Traditional loans (covenant-heavy), on the other hand, have maintenance covenants, which require an issuer to be meet specific financial criteria at regular intervals, whether or not the issuer is undertaking a specific action.

​​Ultimately, the analysis of bond covenants should be part of the analytical process or framework as it makes investors aware of their contract with the issuer. Should there come a time when covenants are in the spotlight or the company is in danger of breaching them, investors who understand their contract will have the ability to act proactively in protection of their capital, principal or investment. There are times when there is no meat on the covenant bone and investors should factor this into their decision and their pricing analysis. There is always another deal, but there is rarely additional protection provided.

The scary part is that​​ the same pattern happened in 2007: remember the credit crisis that followed....

May be we unable to learn from past mistakes...​​
US Credit Markets: My US Lite Rita Covenant: Freshness without Protection ?   $BONDS, $JNK, $HYG

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