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Fixed-Income Insights

Loans with less stringent financial requirements have gained in popularity. What are the implications for investors? 

Leveraged loan issuance is booming, as demand from issuers of collateralized loan obligations (CLOs) and loan funds reaches record levels.1 But could this rapid growth lead to a significant overall decline in underwriting standards—and potential heartache for bank-loan investors?

The bank-loan market came under fresh scrutiny on October 24, when the Federal Reserve and the Office of the Comptroller of the Currency (OCC) issued letters to major banks revealing concern about underwriting standards and warned the banks about deficient underwriting practices. The regulators recommended that banks avoid originating loans that might have some deficiency that could result in a loss. These "criticized assets" include loans that range from those with potential weaknesses that deserve management's close attention to those that may be considered uncollectable.2

Many investors, mindful of the ill effects of previous episodes of lax loan underwriting by major banks, were alarmed by press reports detailing the communication from the Fed and OCC. But investors' concerns need to be placed in perspective. First, it should be noted that this was not a special analysis conducted because of the increased popularity of leveraged loans. It was simply the latest annual installment of a review program that started in 1977.

Second, while the "criticized" loans singled out by regulators amounted to 42% of leveraged loans that were reviewed in 2013, that figure represents a notable improvement over the 51% level in both 2012 and 2011. The regulators' report also points out that "the overall severity of [loan] classifications declined," and "loans that are rated either doubtful or loss account for 0.7% of the portfolio compared with 1.2% in the prior review."3 This is not to suggest that the bank-loan asset class is improving in quality but that investors need to scrutinize seemingly sensational headlines carefully before acting upon hasty conclusions.

On Regulators' Radar
The recent report reflects new leveraged lending guidelines issued in March 2013 that outline regulatory expectations that banks "should evaluate and monitor credit risks in their leveraged loan commitments and ensure borrowers have sustainable capital structures," according to Bryan Hubbard, an OCC spokesman.4

Concern on the part of bank regulators regarding bank-loan quality may have another purpose. The Fed's quantitative easing efforts are designed to reduce Treasury yields, and induce purchase of riskier assets, in order to pull down the broad level of interest rates. To the extent investors respond to low Treasury yields by favoring riskier assets such as bank loans, the Fed bears some responsibility for this behavior. A reminder by the Fed to banks to be conscious of the March 2013 guidance regarding covenants, capital structures, and repayment assumptions may prevent deterioration of bank loans that have been increasingly purchased by individuals through mutual funds and exchange-traded funds (ETFs) and by institutions through CLOs.

Certainly, growth in the asset class and in attendant investor interest should attract the notice of regulators. According to J.P. Morgan, retail inflows into loan funds in 2013 (through mid-October) exceeded $55 billion, more than three times the previous annual record of $17.9 billion in 2010. It is not surprising that this investor shift toward credit risk might cause some concern by bank regulators, especially when it may involve an unmanaged portfolio such as an ETF. Unlike managed funds, an ETF may not discriminate among bank loans. In their effort to replicate an index, ETFs could purchase overpriced issues as well as marginal credits that fail to provide adequate protection to investors.

The growth in CLOs may be equally concerning to the Fed. According to J.P. Morgan, U.S. CLO issuance volume (through mid-October) exceeded $65 billion, compared with $55 billion for all of 2012. Although this level falls short of the CLO volume of about $90 billion in both 2006 and 2007, the levered structure of CLOs may remind regulators of the similar structures of collateralized mortgage obligations (CMOs) in those years. The CMOs contained poor quality subprime mortgages that went into distress, reverberating throughout the U.S. financial infrastructure in the recession of 2008–09.

Echoes of 2006–07?
However, although the structure of CLOs may echo that of CMOs, it is the underlying collateral that defines performance. There were CMOs created in 2006 and 2007 with healthy mortgages that remain unimpaired today due to the higher quality of the underlying mortgages. And many commercial mortgage-backed securities (CMBS) performed admirably over the past several years thanks to better underwriting standards than those for residential subprime mortgages, including adequate documentation and appropriate due diligence. It was the poor performance of the subprime mortgages underlying CMOs, including "no documentation" loans, "liar" loans, and NINJA (no income, no job application) mortgages that wreaked financial havoc once the underlying assumption of ever-upward home appreciation clashed with job losses and economic weakness in 2008–09.

The euphoria of 2006 and 2007 that drove irresponsible subprime underwriting is dramatically different than the economic skepticism and slow pace of lending today. And the guidance collectively issued in March 2013 by the Fed, the OCC, and the Federal Deposit Insurance Corporation outlines heightened standards for bank underwriting practices and describes minimum expectations for financial institutions with substantial exposure to leveraged lending activities. The guidance includes, among other issues, suggested underwriting standards that would in effect avoid leverage in excess of six times total debt to a borrower's earnings before interest, taxes, depreciation, and amortization (EBITDA) and that underwriters should consider a borrower's ability to repay a significant portion of total debt over the medium term (50% of total debt over five to seven years) under projections that include realistic downside scenarios.5

Although guidance, and when necessary, warnings from bank regulators, will hopefully prevent deteriorating underwriting standards and help minimize excessive risk-taking by lenders, they do not assure performance or guarantee solvency of the borrower. In the best case, regulators may improve the quality of the pool of loans that banks create, but investors remain responsible, generally through credit analysis, for distinguishing among those loans to avoid problems and capture opportunities.

Credit analysis is more than the last line of defense against underwriting oversights. Effective credit analysis can guide investors away from loan investments that are overpriced, identify loans of well-managed companies that are favorably positioned, and screen out loans that are aggressively structured and entail more risk than the investor is willing to take. Those risks can include excessive leverage, lack of equity, or lack of loan covenants protecting investors from a borrower's deteriorating financials.

Seeing the "Lite"
It is this last point—a trend toward "covenant-lite" loans—that has attracted recent headlines. Covenant-lite issues generally refer to those with an absence of maintenance covenants, which require the borrower to keep within certain financial ratios, typically on a monthly or quarterly basis. Failure to maintain terms of the loan covenant can constitute default, allowing lenders to force repayment of the entire loan or, more likely, negotiate changes to the loan agreement that avoid default.

Absence of such covenants can remove an effective early warning system to investors. Standard & Poor's estimates that almost 60% of first lien loans issued in 2013 can be characterized as "covenant-lite."6 With continued investor demand from both institutional and mutual fund investors, this trend toward covenant-lite issuance seems unlikely to change soon.

With issuance of covenant-lite loans now dominating bank-loan structures, what becomes important is the likelihood that the protection that covenants would have provided will be needed. In other words, covenant protection is generally not found in investment-grade bank loans because credit analysis suggests that these companies will continue to perform well and their financial ratios and debt structure will not be compromised. Essentially, expectations for company performance obviate the need to demand corrective behavior via covenants.

Similarly, identifying lower-rated companies with strong management, effective capital structure, and attractive financial prospects can allow investors comfort without covenant protection. Many lenders would argue that it has been the financially stronger credits that have been permitted to borrow with covenant-lite terms, while weaker credits have been required by lenders to include protective covenants. Although there is no guarantee leveraged loans will perform similarly in the future, this perspective seems supported by the performance of covenant-lite loans, which have had historically fewer defaults than, and have had recovery rates comparable to loans with maintenance covenants.7

A Watchful Eye
Nonetheless, it would be unwise to assume that covenant-lite means higher quality. Indeed, prudent investors would be well served to assume that covenant-lite terms could quickly extend to poorer quality companies. A healthy dose of skepticism can be part of every professional analyst's arsenal, and thorough credit analysis should be part of every bank-loan investment decision. A company's creditworthiness and expected financial performance are likely much better determinants of investment success than the inclusion or exclusion of covenants.

Putting aside the headlines and the hype, the key point to remember is that leveraged loans, like other fixed-income categories, demand thorough credit analysis to uncover risks—and identify opportunities.


1 "Leveraged Loan Fund Inflows Accelerate to $746 Million This Week," LeveragedLoan.com, October 25, 2013.
2 "Shared National Credits Program 2013 Review," Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, September 2013.
3 Ibid.
4 Kristen Haunss, "Fed Said to Issue Warning about Lax Loan Practices," Bloomberg, October 24, 2013.
5 "Federal Banking Agencies Revamp Guidance on Leveraged Lending," Simpson Thacher, March 27, 2013.
6 "Free Ride: Sponsors Chip Away at Restrictions on Incremental Loans," Standard & Poor's, October 25, 2013.
7 "CLO 1.0 versus 2.0 - Part II of a Series: Cov-Lite Loans," Milbank, Tweed, Hadley & McCloy LLP, July 24, 2013.

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