What is covenant-lite loan?

Last year, lenders to American shoe-chain company Nine West found themselves in a bind as they had to wait on the sidelines when the borrower’s debt surged higher than its earnings. The investors could do little to protect their debt advances: In search for higher yields, they had, in part, sacrificed the rights to the residual assets on bad loans extended to companies such as Nine West.

The reason: the company’s loans were “covenant-lite”, meaning lighter obligation to repay debt, thus raising default risks. This has raised concerns world-wide about high-yielding cove-lite loans/bonds, seen as a prelude to a looming financial crisis.

1. What is cove-lite loan?
A type of loan whereby financing is given with limited restrictions on the debtservice capabilities of the borrower. The issuance of covenant-lite loans means that debt is being issued, both personally and commercially, to borrowers with less restrictions on collateral, payment terms, and level of income.

2. What prompts lenders to sell cove-lite loans?
It is the search for higher yield when the economy is in fine fettle, while ignoring risks. This could well mar the prospect of a debt-saddled economy, with ripple effects in the system.

3. What happened to Nine West?
Nine West was saddled with about $1.7 billion of debt lingering after a $2.2 billion buyout two years ago by Sycamore, Bloomberg reported on September 27 last year. Covenants prevent borrowers from taking actions that could hurt creditors. Of late, Weight Watchers International Inc. also caused similar headaches for their lenders.

4. Are cove-lite loans rising?
Bloomberg reported that 65% of the leveraged loans issued in the first half of 2016 were of cove-lite nature. This compares with no cove-lite debt being issued in 2010, when complacency was low.

So, what is the current status? Not much is in public domain. However, cov-lites have not yet raised any amber alert.

(With inputs from Bloomberg)