Covenants Signs of a Covenant Bubble' Suggest Future Risks for Investors Quest for yield could leave creditors vulnerable in a downturn

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1 MAY 20, 2013 CORPORATES SPECIAL COMMENT Covenants Signs of a Covenant Bubble' Suggest Future Risks for Investors Quest for yield could leave creditors vulnerable in a downturn Table of Contents: SIGNS OF A COVENANT BUBBLE EMERGE 2 CREDIT RISKS REMAIN IN THE BACKGROUND FOR NOW 3 CONDITIONS COULD CHANGE SUDDENLY 7 MOODY S RELATED RESEARCH 9 Analyst Contacts: NEW YORK Christina Padgett Senior Vice President christina.padgett@moodys.com Brian Silver Analyst brian.silver@moodys.com Alexander Ross Associate Analyst alexander.ross@moodys.com Tom shella Managing Director - US and Americas Corporate Finance tom.marshella@moodys.com» Signs of a covenant bubble emerge. Robust issuance of covenant-lite loans and highyield bonds with weak investor protections suggest a covenant bubble that could leave fixed-income investors vulnerable in a credit cycle downturn. The quest for yield is driving looser covenant terms that may not reflect debt issuers underlying credit fundamentals. In a distressed situation, these looser covenants would limit creditors rights. As strong issuance narrows credit spreads, investors may not be fully compensated for the risks they are taking on.» Risks remain in the background for now. While covenant-lite loans and weakening bondholder protections pose risks, investors are unlikely to face a reckoning owing to weak covenants in the next 12 months. Our proprietary indexes of speculative-grade liquidity, covenant stress and refinancing risk all point to favorable conditions for leveraged finance, including solid liquidity and a very low default rate.» Conditions could change suddenly. While we do not consider the covenant bubble to be a near-term concern, conditions could change suddenly. The Federal Reserve s eventual shift to tighter monetary policies and higher interest rates could weaken liquidity in the leveraged finance market and place more stress on low-rated companies. Recoveries on defaulted covenant-lite loans were relatively high in 2009 due to the significant influx of liquidity from the Fed and a cushion of subordinated debt, but the policy response is unlikely to be as robust in the next downturn. Investors acceptance of weak covenants today could lead to lower corporate family-level recoveries in future defaults. The cov-lite lenders generally would be protected by layers of subordinated debt, while subordinated bondholders would likely suffer the deepest losses.

2 Signs of a covenant bubble emerge Whether or not record bond and loan issuance points to a bubble in the US corporate fixed-income markets, we do see signs of a covenant bubble driven by strong investor demand for higher-yielding instruments at a time of low interest rates. Credit metrics of US speculative-grade companies have held relatively steady over the past five years, suggesting that the quest for yield, rather than changes in debt issuers underlying credit quality, is a primary driver of looser covenant terms. Indeed, companies are having little trouble finding takers for covenant-lite loans and high-yield bonds with fewer investor protections. Institutional covenant-lite loan volume approached $80 billion in the first quarter of 2013, close to the total for all of 2012, according to Thomson Reuters. Issuance of high-yield bonds in the US was up 16.4% year-to-date through May 18 versus the year-ago period, according to Moody s Ratings Database. But bond covenant quality has deteriorated significantly, as shown by Moody s Bond Covenant Quality Index, which is near its record low. Most recently, it was at 3.94 on our five-point covenant quality (CQ) scale, in which 1.0 denotes the strongest investor protections and 5.0, the weakest. The high volume of issuance as investors reach for yield amid low interest rates suggests that covenant structures are becoming more a function of market demand than a reflection of companies underlying credit risks. Investors willingness to assume more risk is also evident in a downward drift in ratings. For instance, there were twice as many new issuers with B3 corporate family ratings in 2012 than there were three years ago. We see a similar change in the overall composition of speculative-grade corporates: 48% of speculative-grade corporate family ratings were either B2 or B3 as of February 2013, compared with 38% three years ago, while the percentage of higher ratings of either Ba3 or B1 has held steady at 29%. Low-rated bonds are showing weaker covenant protections. Among new high-yield bond issues rated B1 or below, through April of this year 35% had CQ scores of , the weak end of the range, compared with 29% in the year-ago period. We have also seen a breakdown in the relationship of higher covenant quality to lower ratings, which normally reflects investors demand for stronger protections to lend to riskier credits. As Figure 1 shows, February was the last month that average covenant quality clearly weakened at each stage down the rating scale. FIGURE 1 Normal Relationship of Ratings and Covenants Broke Down in ch and April Feb Apr-13 Historical Avg. Scores 5.00 Ba B Caa/Ca All Spec-Grade Source: Moody s High-Yield Covenant Database 2 MAY 20, 2013 SPECIAL COMMENT: COVENANTS: SIGNS OF A COVENANT BUBBLE' SUGGEST FUTURE RISKS FOR INVESTORS

3 With issuance rising, the pool of covenant-lite loans is widening to a broader array of companies, whether justified by the fundamentals or not. This includes those without private equity sponsors, first-time issuers of cov-lite debt, lower-rated companies and companies with less subordinated debt in their capital structures to provide cushion for the cov-lite loans. In terms of analyzing cov-lite loans, two scenarios are relevant. First, a cov-lite capital structure allows for increased financial flexibility at a time when a company needs it most, potentially allowing it to forestall default while getting through a choppy patch in its business. On the other hand, cov-lite loans can allow a company s fundamentals to deteriorate for a longer period of time, leading to weaker recoveries in an eventual default. The assumption underlying both scenarios is that cov-lite issuers are less likely to default, but once they do, value may have deteriorated to a greater degree than it would have if lenders had been able to step in earlier to address a breached covenant. Regardless, the cov-lite structure creates an opportunity for companies to take more financial and operational risks and transfers influence in a distressed credit from lenders to shareholders. Despite these risks, fixed-income investors may be taking comfort from the track records of the companies to which they are lending. While cov-lite issuance volume has increased dramatically, much of the increase represents refinancing and repricings of existing debt. Just 17% of cov-lite loans issued during the first quarter of 2013 were new money, according to Thomson Reuters. The high proportion of issuance represented by refinancing of existing debt shows that while cov-lite lenders are forgoing protections, most are doing so without materially increasing borrower financial leverage. Investors also are willing to risk lending to companies with less covenant protection at a time when corporate liquidity is solid and the US speculative-grade default rate is low. But with strong issuance driving credit spreads narrower, investors may not be fully compensated for the risks they are taking on. Leverage is creeping up, albeit modestly, which could lead to additional pressure on valuations once the credit cycle turns. Through weak or absent covenants, borrowers are acquiring operating flexibility well beyond the low cost of debt capital. Credit risks remain in the background for now Although the proliferation of covenant-lite loans and high-yield bond covenants with minimal protections may pose credit and interest rate risks for investors in the future, for the moment these risks remain in the background. The outlook for speculative-grade companies appears favorable at least for the next year, with solid liquidity and few defaults on the horizon. Therefore, investors are unlikely to face a reckoning owing to weak covenant protections in the next 12 months. While we have noted a downward drift in the composition of speculative-grade ratings, credit quality of speculative-grade companies has not deteriorated along with covenant protections. Increases in leverage have been modest to date and it remains below 2008 levels, despite heavy debt issuance, because much of the issuance is being used for refinancing. Leverage is also contained by a relatively limited amount of leveraged buyout and secondary buyout activity, which represented about 10% of leveraged loans in the first quarter of 2013 and about 20% in the prior quarter, compared with 36% at the peak in 2007, according to Morgan Stanley Research. Higher leverage also has been mitigated by improving interest coverage, as refinancing drives down the cost of capital and a slowly improving economy supports modest cash flow growth. 3 MAY 20, 2013 SPECIAL COMMENT: COVENANTS: SIGNS OF A COVENANT BUBBLE' SUGGEST FUTURE RISKS FOR INVESTORS

4 What is a Covenant-Lite Loan? While we believe there is no definitive opinion of what covenant-lite actually means, the following elements are typical: Debt Incurrence Covenants: In the most direct and common form of covenant-lite, maintenance covenants are eliminated and replaced with bond indenture incurrence-style covenants. Maintenance covenants require a company to maintain certain ratios such as Debt/EBITDA or EBITDA/Interest Expense that could be violated if the financial condition of the company were to deteriorate. The covenant is measured periodically, usually quarterly or monthly. Conversely, an incurrence covenant only restricts a company from taking certain actions such as raising new debt and cannot be violated simply due to deteriorating financial condition. The company has to take affirmative action to breach an incurrence covenant by additional borrowing. Thus, the potential to breach a covenant is much more effectively in the control of the issuer and its private equity sponsors with incurrence covenants than when maintenance covenants are in place. Carve-Outs: Less direct forms of cov-lite include carve-outs in traditional maintenance covenants that forgive in advance variations in financial performance or permit creative add-backs such as:» Anticipated cost savings or earnings that have not yet been achieved from a restructuring» Expected EBITDA associated with recent acquisitions» Asset sales» Litigation allowances Excessive flexibility: Cov-lite provisions can give an issuer the ability to deviate from expected performance in regard to maintenance covenants. In these cases, the traditional 15% to 20% cushion versus the bank model can exceed 50%. Equity cures: An equity cure enables the issuer s sponsor to cure a covenant deficiency by adding equity to EBITDA, thereby preventing a potential breach and again permitting the option of control to be in the hands of the private equity sponsors rather than lenders. It is a notably less-expensive way to cure a breach than a negotiation with lenders. 4 MAY 20, 2013 SPECIAL COMMENT: COVENANTS: SIGNS OF A COVENANT BUBBLE' SUGGEST FUTURE RISKS FOR INVESTORS

5 Liquidity remains quite robust, as shown by our key liquidity, covenant and refunding indexes. Moody s Liquidity-Stress Index (Figure 2) was near a record low as of mid May, indicating a continuing lack of widespread liquidity problems at speculative-grade companies 1. Moody s Covenant Stress Index, in the same exhibit, is at a record low, a sign that few companies are experiencing tight headroom under financial maintenance covenants 2. And Moody s Refunding Index (Figure 3) indicates that the modest level of upcoming speculative-grade debt maturities will not be taxing for bond market capacity 3. FIGURE 2 Moody s Liquidity Stress and Covenant Stress Indexes at Lows 25% Moody's Liquidity-Stress Index Covenant Stress Index 20% 15% 10% 5% 0% Apr-06 Jul-06 Oct Apr-07 Jul-07 Oct Apr-08 Jul-08 Oct Apr-09 Jul-09 Oct Apr-10 Jul-10 Oct Apr-11 Jul-11 Oct Apr-12 Jul-12 Oct Apr-13 Source: Moody s Investors Service FIGURE 3 Moody s Refunding Index Shows the ket Should Easily Absorb Maturities 25.0x 1 - Year Moody s Refunding Index 3 - Year Moody's Refunding Index 20.0x 15.0x 10.0x 5.0x 0.0x May July Sept Nov May July Sept Nov May July Sept Nov May July Sept Nov May July Sept Nov June Aug Oct Dec Feb Apr Source: Moody s Investors Service 1 Moody s Liquidity-Stress Index reflects the percentage of US non-financial companies with speculative-grade liquidity (SGL) ratings that have the weakest liquidity score of SGL-4. 2 Moody s Covenant Stress Index reflects the percentage of SGL-rated companies that have the weakest score of 4 for the covenant component of the SGL rating. 3 Moody s Refunding Index is a ratio of debt issuance to upcoming maturities. It increases as refinancing risk declines. For more information, please see Moody s Refunding Index: Frequently Asked Questions, February MAY 20, 2013 SPECIAL COMMENT: COVENANTS: SIGNS OF A COVENANT BUBBLE' SUGGEST FUTURE RISKS FOR INVESTORS

6 These measures support our benign default rate forecast (Figure 4). The trailing 12-month US speculative-grade default rate was low at 3.1% in April. Based on Moody s forecasting model, we expect the default rate to fall to 2.7% by the end of this year and to 2.4% a year from now. Until the default rate rises, investors should largely remain unscathed by the risks they assume as they forego more protective covenants, although they do remain exposed to rising interest rates. FIGURE 4 Baseline Forecast Predicts Low Default Rate 16% 14% 12% 10% 8% 6% 4% 2% 0% Apr-93 Nov-93 Jun Aug Oct-96 May-97 Dec-97 Jul-98 Feb-99 Sep-99 Apr-00 Nov-00 Jun Aug Oct-03 May-04 Dec-04 Jul-05 Feb-06 Sep-06 Apr-07 Nov-07 Jun Aug Oct-10 May-11 Dec-11 Jul-12 Feb-13 Sep-13 Source: Moody s Investors Service Actual Default Rate Baseline Forecast Pessimistic Forecast Optimistic Forecast When defaults do occur at companies with covenant-lite loans, the cov-lite lenders themselves generally will be protected by layers of subordinated debt. Cov-lite issuers tend to be owned by private equity firms, typically among the most financially sophisticated and aggressive issuers, which employ layers of debt at sponsored companies. In most cases, these companies have corporate family ratings of B2, with the cov-lite loan typically rated one notch higher at B1. The higher rating reflects the benefits of maintaining subordinated debt to absorb the brunt of the losses in a distressed scenario. FIGURE 5 Characteristics of Covenant-Lite Loans First Quarter 2013 Fourth Quarter 2012 Private Equity Sponsor 72% 65% Median Corporate Family Rating B2 B2 Median Loan Rating B1 B1 % B1 CFR 11% 19% % B2 CFR 66% 58% % B3 CFR 16% 15% % Other CFR 7% 8% % Without Cushion 16% 15% Source: Moody's Investors Service, Thomson Reuters Although covenant-lite loans limit lenders ability to force a struggling company to restructure, lenders generally receive strong recoveries once default occurs because, like holders of all secured first-lien debt, they benefit as lower tranches absorb losses first. Our 2011 study of covenant-lite defaults and recoveries showed an average recovery for first-lien loans of 89.6%, while senior subordinated bonds 6 MAY 20, 2013 SPECIAL COMMENT: COVENANTS: SIGNS OF A COVENANT BUBBLE' SUGGEST FUTURE RISKS FOR INVESTORS

7 had an average recovery of just 23.1% 4. Figure 6, reproduced from that report, shows average recoveries in capital structures with a covenant-lite loan (left column) in comparison with a sample of companies that emerged from default during the Great Recession 5. FIGURE 6 Instrument Recovery Rates Hard Data for Hard Covenant-Lite Study Times II Study First Lien Loans (all cov-lite loans were first lien) 89.6% 81.5% Subordinated Loans (Second Lien and Unsecured) 5.6% 29.3% Senior Unsecured Bonds 47.2% 42.6% Senior Subordinated Bonds 23.1% 27.6% Source: Moody s Ultimate Recovery Database Conditions could change suddenly While we do not see the covenant bubble as a near-term concern, weaker covenant protections pose more risk for investors in the future. Right now, speculative-grade companies are benefitting from a benign credit environment, with reliable market access and moderate funding costs. But these conditions could change suddenly. A key issue is the Federal Reserve s monetary policy. The Fed has kept interest rates exceptionally low and has committed to maintaining its current stance until there is substantial improvement in the labor market. The Fed s eventual shift to tighter monetary policies and higher interest rates could shift market dynamics abruptly. A lack of liquidity in the leveraged finance market would lead to more distress among low-rated companies, sending investors back to their credit agreements to analyze their covenant protections. The Fed reacted to the credit cycle downturn with an unprecedented influx of liquidity that it is unlikely to repeat in the next downturn. An eventual negative turn in the credit cycle, therefore, would leave investors with fewer levers to retain value, particularly in light of the preponderance of weak and absent covenants in recent issuance of high-yield bonds and leveraged loans. As a consequence, corporate family-level recoveries could be lower during the next downturn than they were last time. Lower family recoveries would be disproportionately punitive to bondholders, who are more weakly positioned in complex capital structures. While loan investors benefit from the senior position of firstlien loans in a company s capital structure and the pledge of most or all of the issuer s collateral, bonds in cov-lite capital structures for the most part have a subordinated claim that leaves them vulnerable to disproportionate losses in a restructuring or bankruptcy filing. It should be noted that we change our recovery assumptions for companies with an all first-lien bank structure that includes a cov-lite loan. In general, we adjust those assumptions from 35% enterpriselevel loss given default, which is our expectation for issuers with all first-lien loans with credit agreements that include meaningful covenants, to 50% for loans that lack adequate protections. We 4 See Covenant-Lite Defaults and Recoveries: Seeing Where It Hurts, June See Hard Data for Hard Times II: The Crisis That Wasn't, February MAY 20, 2013 SPECIAL COMMENT: COVENANTS: SIGNS OF A COVENANT BUBBLE' SUGGEST FUTURE RISKS FOR INVESTORS

8 would also expect much greater losses for all first-lien structures without subordinated debt. Loans with well-structured bank debt defined as bank debt with a cushion of 40% or greater have about 89% average ultimate recovery versus all other bank debt recoveries of 58% 6. When the default rate eventually rises, the timing of defaults and preponderance of distressed exchanges will be key wild cards determining the recovery experience for investors. If interest rates are rising because the economy is gaining strength, recoveries will likely be higher because better economic prospects will support asset values. If there is a rush of defaults and many companies are restructuring at the same time, however, recoveries will likely be lower because buyers of distressed assets will have more leverage. Finally, if a lot of defaults occur via distressed exchange a distinct possibility if many of the companies are private equity backed with covenant-lite loan structures corporate family recoveries could benefit because losses would be isolated to the investors participating in the exchange. Distressed exchanges accounted for about 15% of defaults until the credit crisis and have accounted for about 40% since 7. If the percentage remains high in the next downturn, there likely will be higherthan-normal recoveries for cov-lite loans. The default rate for cov-lite issuers tends to be lower than for the rated North American corporate universe, according to our cov-lite study. While the lower historical default rate comes as no surprise, considering that the primary motivation for a cov-lite capital structure is to avoid a default via a covenant breach, it is interesting that nearly half of the defaults took the form of distressed exchanges, which led to higher-than-average recoveries for the cov-lite lenders. Distressed exchanges are one of private equity s preferred tools for staving off a bankruptcy filing for portfolio companies. The private equity firm is able to maintain its stake in the issuer while lowering the debt burden, which affords the issuer more financial flexibility to potentially recover from distress. This strategy preserves value for the private equity sponsor and also tends to leave the top of the capital structure unscathed. However, it should be noted that distressed exchanges that do not sufficiently resolve a company s credit stress tend to be followed by additional default events that impose additional credit losses. 6 Source: Moody s Ultimate Recovery Database, which contains information on more than 4,100 loan and bonds that have defaulted since See Distressed Exchanges: A Lifeline for Many, Not Enough for Some, ch MAY 20, 2013 SPECIAL COMMENT: COVENANTS: SIGNS OF A COVENANT BUBBLE' SUGGEST FUTURE RISKS FOR INVESTORS

9 Moody s Related Research Special Comments:» North American Covenant Quality Index: Bond Covenant Quality Remains Low In April, May 2013 (153864)» SGL Monitor: Liquidity-Stress Index Rises From Record Low, May 2013 (153927)» Strength of Corporate Issuance and Prices Not Necessarily Indicative of a Bubble, May 2013 (151673)» Leveraged Finance Interest North America Edition (Newsletter), May 2013 (153581)» 12 Most-Active Private Equity Sponsors Provide Weak Covenant Packages, April 2013 (152178)» It's Risk-On for Private Equity, November 2012 (147409)» Covenant-Lite is Back, Along With its Risks, uary 2012 (139198)» Lessons from 1,000 Corporate Defaults, November 2011 (137405)» Covenant-Lite Defaults and Recoveries: Seeing Where It Hurts, July 2011 (133473)» Covenant-Lite Loans May Prove Riskier in the Next Downturn, ch 2011 (131595)» Distressed Exchanges: A Lifeline for Many, Not Enough for Some, ch 2011 (131726)» Cheating Death: Private Equity Manages Solid Recoveries When Sponsored Companies Default, November 2010 (128561)» Safeguards for Lenders When Private Equity Layers on Debt, September 2009 (120167) To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this report and that more recent reports may be available. All research may not be available to all clients. 9 MAY 20, 2013 SPECIAL COMMENT: COVENANTS: SIGNS OF A COVENANT BUBBLE' SUGGEST FUTURE RISKS FOR INVESTORS

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