Call for greater transparency in leveraged loans

Call for greater openness in leveraged loans
By Stacy-Marie Ishmael

(FT June 13) Investors should demand more transparency and accountability from managers of collateralised loan obligations, according to a new report from Standard & Poor’s.

The rating agency said the the rising popularity of so-called covenant-lite loans imposed significant risks on investors in the opaque CLO market.

Demand for CLOs, complex financial instruments which repackage portfolios of loans, has surged recently. The products can offer investors better returns for a given rating than traditional fixed-income assets.

In the first quarter of 2007, global covenant-lite loan volume reached $48bn, compared with $24bn recorded for the whole of last year. The use of these loans to fund buy-outs is already well-established in the US and becoming more accepted in Europe.

But S&P said the absence of the traditional covenants that give creditors early warnings of financial problems diminished recovery prospects for such loans.

“Cumulative credit risk to lenders and players in the risk transfer chain is building as covenant strength is evaporating,” S&P said in its report. The agency said it was adjusting its CLO rating criteria to reflect the increased risk.

Abundant liquidity and the disproportionate power of borrowers, arrangers, and financial sponsors have allowed a growing segment of high-risk companies to issue covenant-lite loans, S&P said. Many of the loans are held in CLOs.

“We suggest that investors ask managers to disclose their cov-lite holdings in their investor letters or reports, and demand more traditional ‘cov-strong’ rather than ‘cov-weak’ protection,” S&P said.

Managers must also be held accountable if they extend credit to borrowers demanding weaker covenants. “We encourage investors to focus in now more than ever on a CLO manager’s ability to differentiate among debt structures, covenant protections, and asset coverage in their asset selection process,” S&P said.

“We feel we should raise awareness before the next cycle turn,” S&P said