As Credit Quality Falls, Deals Flourish

Credit quality is falling, but that doesn't seem to bother banks. According to a new report from Fitch Ratings, not only are banks making lower-rated deals, but they're doing so far more often -- syndicated loan volume has soared 60% in the last two years -- and with fewer and fewer restrictions.

According to the Fitch report, released yesterday, the typical number of covenants – tests, requirements and restrictions designed to cut down on the risk of a loan – fell to five from six last year. More troubling, the number for junk loans fell from eight to six in 2005. To top it off, according to the Federal Reserve, bank lending standards are at a 10-year low.

"In essence, it's a borrower's market currently, and the banks are making concessions to get deals done," Mariarosa Verde, who heads Fitch's credit market research team and is a co-author of the report, told InstitutionalInvestor.com. In particular, she points to the decline in the use of debt-to-cash flow restrictions, which fell from 68% to 57% in the non-investment grade loans, with senior debt-to-cash flow restrictions declining from 24% to 15%.

"The fact that that covenant is not appearing as often as it did a year ago means that companies have more leeway in terms of adding leverage," she says, with a consequent increase in default risk.

The cyclical decline of covenants is not unusual; according to the report, when credit quality declines, the number of debt-to-cash flow covenants increase. Last year, though, that inverse relationship, for the first time in a decade, disappeared, with both credit quality and covenant usage falling.

"You had simultaneously riskier credits and less covenant protection," William May, a senior director with Fitch and Verde's co-author, says.

That, according to May, isn't only bad for the banks, in the long run. "All of a company's creditors tend to be beneficiaries of strong loan covenants," he says, since they help cut down on default risk. "As covenant packages weaken, there's in a sense less cops on the beat. This is going to impact not just the loan investors but the bond investors as well."