Analysts of corporate credit have recently expressed concern about a possible bubble in corporate loans fueled by low interest rates, yield hungry investors, and a slowdown in the Federal Reserve's bond buying program. The New York Times even described the recent growth of so-called "leveraged" loans to riskier borrowers, which achieved record issuance in 2013, as a new type of subprime lending--reminiscent of the shoddy lending practices that fueled the mortgage boom prior to 2007.
Much of the focus of the recent growth in corporate loans centers around the fact that they are increasingly being structured with fewer financial covenants. These covenant-lite loans lack the usual promises by borrowers to maintain a certain level of performance, and thereby create a risk that lenders may not be able to protect their investments until it's too late.
But concerns about the growth of covenant-lite loans are largely misplaced. Although the use of covenant-lite loans has sky rocketed, their growth is being balanced out by fact that they are being dolled out only to strong companies and major investors are sticking to their preestablished limits on investing in the loans. There's no doubt that corporate loan terms have recently become more borrower-friendly, but not worryingly so.
Covenant-lite loans seem to be a healthy response to broader market trends that make sense within the context of loan structures that already provide plenty of protection for borrowers. Indeed, long before covenant-lites took a foothold in the corporate loan markets, another type of corporate loan was always "lite" on financial covenants, and not as a result of market dynamics, but by design. These loans are known as asset-based loans. Asset-based loans are a unique type of secured loan whereby the lender engages in extensive monitoring of loan collateral. The value of the collateral also determines how much credit is available to the lender at any given time.
Because asset-based lenders intensely monitor collateral and adjust the size of the loan based on collateral performance, they are comfortable easing up other terms. A typical asset-based loan includes few financial covenants, if any. Asset-based lenders are also usually willing to charge lower interest rates compared to traditional loans. As a result, asset-based loans are often the only type of loan available to high-risk borrowers.
"Asset-based lending is often temporary, providing much-needed working capital during a start-up or transition phase until the company has enough financial history or a strong enough balance sheet to become bankable," says Tracy Eden of the Commercial Finance Group. High-tech startups are probably a segment of borrowers that could stand to benefit from more asset-based loans as well.
Asset-based loans seem to be on a strong growth trajectory, but regulators and market participants exposed to risk from the loans don't have much reason to worry. Despite the fact that asset-based loans are often made to riskier borrowers, the loans are conservative structures with relatively low default rates and losses. During the financial crisis, funds that invested in the loans certainly saw their share of losses and closures due to investor redemptions, but by most accounts fared much better than investors in non-asset-based loans and other popular assets.
Asset-based loans may lack financial covenants, but there's nothing subprime about them.
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