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A long stretch of historically low interest rates and defaults, combined with growing demand for loans among institutional investors, fueled a surge in "covenant-lite" loan structures in the years after the Global Financial Crisis (GFC). While this shift to a market in which a large majority of loans lack financial maintenance covenants is a drag on recovery rates for defaulted first-lien term loans, other factors are in play.

What We're Watching

Financial maintenance covenants were once a standard feature for loans. They gave lenders the ability to influence borrower behavior in ways designed to protect investors if a borrower's credit quality declined below set limits--e.g., by limiting dividends, tightening collateral packages, or reducing revolver availability.

Rather than triggering a default, covenant violations tend to result in the repricing of a loan (with higher margins, fees, or both) to reflect the higher credit risk. But these added costs put more pressure on companies and can push them into default earlier than might otherwise be the case--whereas the lack of maintenance covenants can provide borrowers some much-needed financial flexibility in times of distress, and (ideally) may allow them to avoid default altogether.

Historical data support the view that the absence of financial maintenance covenants weighs on ultimate recovery rates for defaulted first-lien term loans. With more than 85% of structures in the U.S. market for broadly syndicated loans (BSL) being covenant-lite, this bodes ill for investors in companies that eventually default.

It's worth noting that covenant-lite loans do carry some covenants. Loan terms still require borrowers to meet incurrence covenants before taking certain actions, such as adding debt, pledging assets, or making restricted payments. (That said, these limits may be less restrictive than they appear because there are often a variety of "free and clear" baskets that may give borrowers additional flexibility to incur debt or make restricted payments without tripping covenants. Also, inflated EBITDA definitions in loan documents may provide companies with more flexibility.)

Tripping a financial maintenance covenant (or getting close to doing so) acts as a catalyst to bring the company back to the table with lenders. On the downside, the added costs that borrowers may incur as a result of renegotiation can push them into default. On the plus side, the earlier the default, the less leakage of enterprise value and, therefore, ultimate recovery.

What We Think And Why

S&P Global Ratings looked at recovery rates of first-lien term loans issued by 67 rated companies that emerged from bankruptcy either through a reorganization or asset sales/liquidation from January 2014-June 2020 (still the most relevant time frame, given the pandemic's profound effects on economies and markets). We found that covenant-lite loans had average and median recovery rates that were 11 and 34 percentage points, respectively, below those on covenanted loans. More recently, first-lien term loans that were covenant-lite averaged a 61% discounted recovery from 2010 to September 2023, nearly 11 percentage points below the average recovery of covenanted first-lien term loans (see chart).

This relative shortfall of covenant-lite loan recoveries compared with covenanted loans' is a fairly recent phenomenon. For loans that emerged from default before 2010, covenant-lite loans averaged a recovery that was nearly three percentage points higher than that of covenanted loans. But since 2010, the average recovery for covenant-lite loans has fallen below that of covenanted loans.

The population of defaulted loans has changed during this period. Before 2010, covenant-lite instruments were scarce among defaulted loans, accounting for less than 1% of the loans for which we have recovery data. But since the GFC, covenant-lite has grown from a minority to the majority of BSL issuance. As a result, covenant-lite loans represent nearly one-third of the loans emerging since 2010, and the share is growing.

However, correlation is not necessarily causation--and we think it may not be practical to draw definitive conclusions about the gaps in recovery rates. While we think that financial maintenance covenants can bolster lenders' recoveries (and we factor this into our analysis so that the presence of covenants generally results in somewhat higher estimated recoveries), other factors are likely more important drivers of recoveries.

At the macro level, the environment in which a borrower defaults is of paramount importance. At a more bullish, "risk-on" stage of the business cycle, enterprise values--and therefore recoveries--tend to be higher; at or near a cycle's trough, they are naturally lower.

At the company level, leverage and debt cushion are the main drivers of recoveries and are important considerations that can boost recovery expectations when we conduct our recovery analysis.

Still, it's reasonable to assume that, on the way to default, borrowers with traditional covenants breach them and lenders then demand higher interest margins or other fees. This implies that a company in such a position would default earlier and at higher profitability than it would have without a covenant breach. All else equal, this prevents further deterioration in enterprise value and thus makes for relatively higher recoveries for lenders.

Even so, covenant-lite term loan structures also provide companies with more flexibility to undertake aggressive out-of-court restructurings that impair lender recovery prospects through collateral transfers, priming loan exchanges, and other emerging tactics such as "double dip" and "pari plus" structures. While these restructurings remain infrequent, they have been increasing in recent years and remain a significant investor concern.

What Could Change

One reason institutional loan investors are concerned about covenant-lite term loan structures is because they went from a concession granted only to speculative-grade (those rated below 'BBB-') borrowers seen as stronger than their peers pre-GFC to one offered to the vast majority of speculative-grade issuers post-GFC amid the prolonged stretch of historically low borrowing costs and defaults.

However, "higher-for-longer" interest rates and rising event risk from aggressive out-of-court restructurings may cause institutional lenders to re-evaluate the benefits of financial maintenance covenants. The Federal Reserve's aggressive monetary policy tightening has brought its key rate to its highest level since September 2007--the start of the GFC. We don't expect the central bank to lower its policy rate before midyear, keeping interest burdens at higher levels through most of 2024.

In this light, S&P Global Ratings Credit Research & Insights expects the U.S. trailing-12-month speculative-grade corporate default rate to reach 4.75% by December, up from 4.5% in December of last year, and with a peak earlier in the year. Credit fundamentals remain strained, particularly among borrowers with the weakest ratings.

While BSL investors may long for the reinsertion of financial maintenance covenants, borrowers are certain to resist, and it's unclear whether institutional investors have sufficient negotiating power or unity to demand their return.

Writers: Molly Mintz and Joe Maguire