Moody’s: Covenant-Lite investors experience differences with default

New York, June 08, 2011 — Creditors to companies with covenant-lite loans do not all face the same degree of risk, says a new report from Moody’s Investors Service. When companies with covenant-lite loans default, subordinated debt holders usually bear the brunt of the losses, cushioning holders of debt that is higher in a company’s capital structure.

There could be deeper losses to come, the report notes, because the erosion of debt cushion in the initial defaults of covenant-lite companies could expose investors to deeper losses in the event of subsequent defaults.

“Covenant-lite loans remove the ability of bank lenders to force a restructuring, allowing more time for management and private equity backers to seek non-bankruptcy options,” says David Keisman, a Moody’s Senior Vice President. “However, this may mean a loss of asset value as an earlier restructuring would have allowed investors to recover more money.”

Covenant-lite default rates have been below average when compared to similarly rated companies and to the historical average. Moody’s review of 104 covenant-lite defaulters shows a 7.8% default rate, compared to 10.35% for rated North American corporate issuers. The default rate for covenant-lite loans alone was 4.1%.

Nearly half of the covenant-defaults were distressed exchanges, which may be a result of the prevalence of private equity backers. Private equity owners were present in nearly 70% of the covenant-lite defaults the report examines. These equity holders often choose distressed exchanges as a means of influencing recovery rates and maintaining their stake in the issuer.