Too much debt is a risky thing, and even the U.S. government is wrestling with the issue of just what level of indebtedness it is comfortable with. Ironically, at exactly the moment that market participants are wondering what happens if the U.S. government hits the debt ceiling, the corporate credit market is busy establishing a debt floor for companies.Perverse incentives are driving a loosening of terms in the corporate credit market, and while the logic may be sound over the short-term, the impact of loose covenants will likely force an economic reckoning in the medium-term. A recent article highlights some worrying examples of the trend toward looser terms in the corporate credit markets. Some examples:
- Delphi Automotive LP issued $500MM of senior notes that included covenants with a carve-out for unlimited dividend payments. The only hurdle Delphi’s owners will need to obey is maintaining a leverage multiple below 3.5x EBITDA.
- Freescale Semiconductor Inc. recently issued $750MM in unsecured notes allowing leverage up to a maximum of 3.25x EBITDA.
Steven Rutkovsky of Ropes & grey, commenting on the practice of restricting dividend payouts via nothing more than a leverage test, notes: “It essentially puts a floor on leverage, because if leverage ever gets below that, they’ll put more on.”
When covenants are loosened lenders essentially surrender their rights and remedies should a company finds itself in distress. The weaker the covenants, the worse shape a debtor will be in before it trips one and the lower the recoveries for those unfortunate lenders. The chase for yield is driving a systemic risk of limited control and lower payouts in worst-case scenarios.