Fitch: Covenants decline in 2006 despite more aggressive U.S. loan ratings mix

By Angela McDaniels

Seattle, Jan. 26 - Fitch Ratings said that while the U.S. leveraged loan market experienced a banner year in 2006 with new highs in issuance levels, low default rates and record deal sizes, loosening structures and disappearing covenants remain a major concern.

In particular, as speculative-grade borrowers increasingly turned to the loan market to meet their funding needs, there continued to be a decline in some of the key covenants designed to monitor borrowers' ability to repay mounting obligations and to serve as an early warning signal should problems emerge, according to an agency new release.

Analyzing rated leveraged loans issued in 2006 that contained at least one covenant, Fitch found that only 41% contained an interest coverage covenant, down from 46% in 2005 and below its 1996-2006 average of 51%.

For coverage covenants of any type in leveraged loans, the frequency was 67% for the full year, down from 69% in 2005 and below its 1996-2006 average of 78%.

Fitch said the trend in covenant package erosion was highlighted by the strength of covenant-light deal issuance, which topped $23 billion in 2006.

After slowing in the third quarter, covenant-light deals came back in vogue during the fourth quarter of 2006 with the financing of Freescale Semiconductor, Inc.'s $4.25 billion covenant-light deal and will likely remain a popular part of leveraged loan deals until the market turns, the agency predicted.

In addition to covenant-light structures, private-equity sponsored deals started to include a greater number of equity cure provisions, which allow borrowers to bypass lenders and add equity into a deal to count as EBITDA without an amendment if the company is not in compliance with its covenants. The additional equity does not have to be used to pay down debt and can be used for different purposes such as capital expenditures.

The decline in covenant protection in the leveraged loan market occurred despite a push into lower-rated credits. Fitch said it found that the downward ratings migration that has characterized the leveraged loan market over the past few years continued in 2006 as the ratings mix of new deals became increasingly aggressive.

In 2006, deals rated B and below as a percentage of total leveraged loan issuance increased to 58.2% from 50% in 2005 and by count represented 66.7% of the market, up from 64% in 2005, the agency said, adding that these figures are based on a composite of the ratings assigned by Fitch, Moody's Investors Service and Standard & Poor's.

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