Credit Risk - US Loan Market Sees Fewer Covenant Protections as Volumes Soar

Accompanying and fueling the dramatic growth of the US syndicated loan market over the past several years has been a steady loosening of lending standards among banks on commercial and industrial loans. A new Fitch Ratings study finds that one consequence of this 'borrower-friendly' funding environment has been a pronounced decline in covenant usage. This trend has been most acute among non-investment grade loans despite a steady decline in the credit quality of newly originated deals.

Fitch's study examines changing covenant standards in the syndicated loan market and discusses the importance of these developments from a credit perspective.

'Covenants are critical in safeguarding loan terms and ensuring that potentially risky managerial actions are checked,' said William May, Senior Director of Credit Market Research, 'With fewer covenants, there are weaker safeguards on borrower behavior.'

Fitch's analysis finds that:

• Lending standards in the syndicated loan market weakened in 2005 with a marked decline in covenant usage and a seeming homogenization in their application;
   
• Covenant usage declined across the investment grade and non-investment grade segments of the market;
   
• Usage of a number of key covenants contracted significantly at the non investment grade level. The number of covenants incorporated into a typical non-investment grade loan package fell to six, down from its 2002-2004 level of eight. The restriction on debt/cash flow, for example, appeared in 68% of loan packages in 2004 but was visible in just 57% of 2005 credit agreements. This occurred despite the fact that the rating mix of new deals in 2005 was more aggressive than the 2004 pool;
   
• The non-investment grade restriction on senior debt/cash flow experienced one of the most dramatic declines in 2005, appearing in just 15% of credit agreements, down from 24% in 2004 and 29% in 2003.
   
• Robust loan market conditions have contributed greatly to the low default environment of the past several years,' said Mariarosa Verde, Managing Director of Credit Market Research. 'That said, the decline in structural protections will very likely set the stage for the next round of credit problems.'