Q.7 Case Study (07 Marks)

Loan covenants are conditions or restrictions specified in a loan contract and represent an important factor in credit analysis. Loan covenants represent promises by the borrower to do or refrain from doing certain things. The usual practices necessitated by loan covenants include maintaining interest coverage, leverage ratios and the lenders position in the companys capital structure (Osterland, 2018).

According to the data from Moodys, in early 2018 the protection of lenders from defaulting companies is now the weakest it has been since records began. Contributing to this, almost 80.00 per cent of leveraged loans were covenant lite, which do not come with certain conditions normally imposed by more comprehensive loan covenants.

The risks inherent in such loans mean that there can be a significant loss in the financial value before lenders can undertake the necessary steps to recover some portion of what they are owed. It has been found that recovery rates following a bankruptcy declaration can differ substantially depending on whether strong loan covenants are in place (Scaggs, 2018). Even in the Australian economy, leveraged loans are often less protected by loan covenants than they once were.

The issuance of covenant-lite corporate loans has expanded rapidly in the past few years, reaching almost 77.00 per cent of the estimated $1 trillion leveraged corporate loan market. Most of these loans are packaged and resold as bonds. KKR, the private equity firm, issued $1.3 billion of such bonds while completing its $8 billion leveraged buyout of Unilevers margarine and spreads business.

Investors who are desperate for better yields in a low interest rate environment have, according to some commentators, already overpaid to a point where they are not being compensated for the risks they have taken (Cohan, 2018). Loan covenants are critical in the sense that they help balance the financing requirements for firms against the risks that investors should be willing to bear given the yields that they have been promised (Understanding Covenants BondAdviser, 2018).

Q.A Explain the role played by loan covenants to protect investors, and how covenant-lite loans affect investors.

Q.B From the point of view of investors in corporate bonds, covenants are critical to assessing yields and risks. Discuss this statement.