Recent years saw a significant increase in “covenant-lite” debt, under which debt contracts had few if any debt covenants. For example, a private equity firm may issue such debt to finance a planned takeover. One estimate is that, in 2007, covenant-lite debt accounted for 35% of all debt issued in the United States.

This debt is typically bought by financial institutions, such as banks. A bank may then combine this loan with other similar loans and slice the total up into tranches, that is, into packages of debt of similar credit quality, called asset-backed securities or collateralized debt obligations (CDO). It will then sell these tranches to investors on a secondary loan market. The purchaser will receive his/her share of the interest and principal payments paid by the firms whose debt is in that tranche. Thus, the investor can buy interest-bearing debt with the level of default risk he/she desires, and pay accordingly. The effect is to disperse credit risk through the economy. It is expected that even for a tranche of low quality there will be no more than a few defaulting firms, so that any credit losses are spread over all the investors in that tranche.

Furthermore, it is possible to increase the credit quality of a CDO by buying credit default swaps (CDS). These are derivative instruments under which the issuer of the CDS, for a fee, agrees to compensate tranche investors for credit losses incurred by that tranche. If CDSs are bought to protect, say, 25% of the underlying debt in the tranche, the effect is to increase the credit quality of the tranche significantly. This further disperses credit risk, since now at least part of the risk is borne by the CDS issuers.

Required

a. If you were an investor in interest-bearing securities, would you be willing to invest a substantial amount of your capital in tranches secured by covenant-lite debt? Explain why or why not.

b. Concerns are sometimes expressed that issuing covenant-lite debt creates a moral hazard problem. What is the problem?

c. What would be the effect of covenant-lite debt on the validity of the debt covenant hypothesis of PAT?

d. The ability to increase the credit quality of high-risk debt by means of CDSs seems almost “magical.” From the standpoint of a CDO investor, do you see a downside to investing in CDOs, particularly if protected by CDSs? Explain.