by Calculated Risk on 6/20/2007 04:37:00 PM

From Fitch Ratings: U.S. Leveraged Loan Covenant Decline Accelerating in 2007

The balance of power in the U.S. leveraged loan market continued to shift from creditor to borrower as protective covenant packages declined further during the first five months of 2007. The deterioration occurred amid vibrant and aggressive overall leveraged loan issuance.

• The percentage of leveraged loans containing a coverage covenant of any type dropped to 44.3% from 68.1% in 2006 and below the 1996–2006 average of 78.1%.

• The percentage of loans containing leverage covenants of any type fell to 51.1%, down from 69.6% in 2006 and below the 1996–2006 average of 72.8%.

• Along with the general demise of covenant packages has been the growth of specific “covenant-lite” loan issuance. In 2007 through May, $47 billion of “covenant-lite” transactions—those typically containing no financial covenants at all—have come to market; more than twice the level of covenant-lite issuance in all of 2006.

Overall lending is still "aggressive". And Fitch is worried:

In nearly any environment, such a radical deterioration in creditor protection would be cause for concern. Exacerbating the current trend, however, is that it is occurring amid an evermore aggressive rating mix of deals coming to market.
...
The near absence of corporate defaults appears to be a major factor behind the decline of key structural protections in the leveraged loan market. ... this lack of defaults is helping to create a self perpetuating and troubling pattern, whereby the low default rate enables deep speculative grade borrowers to get easy access to the loan and bond markets, and at increasingly favorable terms, as shown by the covenant trends discussed above. The result: nearterm defaults are avoided, which fosters some level of complacency and higher risk tolerance, ultimately allowing new issuance to take on even more aggressive characteristics. However, should economic growth soften more than anticipated or some other shock hit the market, the growing share of low quality loans and bonds ... will come under significant pressure. In other words, while defaults remain very low, risk in fact continues to move in the opposite direction.