The Case for Covenants (Part Two)

An astute Lead Left reader appreciated the first part of our special series on covenants. He alerted us to a ironic development Friday in the high-yield bond market. According to Bloomberg, bondholders of the commodities trader, Noble Group, saw values drop below 50 cents on the dollar on a negative earnings surprise. Apparently the bonds had been sold in March with only investment grade covenants.

Unlike junk bonds with incurrence tests, Noble’s securities only had a change of control and negative asset pledge. No asset sale or dividend limits. Let’s call it “cov-lite-lite.” One analyst put it, “When things are good, people don’t pay attention to covenants, but when things sour, covenants are their only line of protection.”

Attaching IG covenants to non-IG borrowers is like having incurrence-only tests for middle market companies – migrating looser terms to issuers of lesser credit quality puts investors in a less-defensible position.

So why are loan arrangers pushing cov-lite for smaller loans? In part, argue some managers, “cov-lite” is the natural evolution from the “cov-wide” trend (or as some dub it, “cov-lame”). That’s where the cushion between the financial covenant test (say, debt to ebitda) and the projected ratio is so large that it becomes meaningless.