April 8 (Bloomberg) -- Moody’s Investors Service has come up with a system to score the covenant quality of leveraged loans, as regulators warn that weak lender protections may signal deteriorating underwriting standards.
The ratings company plans to detail in a report today how the new criteria works, according to Jessica Reiss, an analyst at Moody’s in New York who focuses on covenants and credit agreements. The scoring system is similar to what the ratings company publishes for bonds.
Leveraged loans, which back buyouts, had a record year of issuance in 2013 with $354 billion of new debt arranged, according to data compiled by Bloomberg. Covenant-light loans, which lack typical lender protections, tripled in 2013, prompting concern about riskier lending by some of the biggest banks among regulators including the Federal Reserve.
“We came up with seven key areas we think are important for loan investors to look at when evaluating a credit agreement,” Reiss said in a telephone interview, noting the scores aren’t ratings.
There were $312 billion of covenant-light loans issued in 2013, up from $105.7 billion the previous year, Bloomberg data show. More loans in 2014 have lacked these lender safeguards than included them, the data show.
The exclusion of “meaningful maintenance covenants” is a sign that “prudent underwriting practices have deteriorated,” the Fed, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. said in a March 21, 2013, statement accompanying the release of leveraged-loan underwriting guidelines.
In the new system, Moody’s will assign a score to seven individual risk categories including: financial covenants; liens and structural subordination; cash leakage; leveraging; investments in risky assets; asset sales and mandatory prepayments; and voting, assignments, incremental facilities and defaults, according to a frequently asked questions document.
The ratings company will assign a score of 1 through 5 to each risk category, with 1 signifying a strong covenant package and 5 meaning the weakest protection, Reiss said. The individual scores are then weighted to come up with an overall score, called an LCQ for loan covenant quality, she said.
An LCQ score is an “assessment of the degree of protection that a leveraged-loan covenant package provides to investors,” according to the FAQ sheet.
The scores will be applied to companies that publicly file and have an institutional term loan that is at least $500 million in size, she said. The scoring only applies to loans assigned a speculative-grade rating on the closing date, according to the report.
Leveraged loans, also called high-yield or junk-rated loans, are made to companies rated below Baa3 by Moody’s or lower than BBB- by Standard & Poor’s. There have been $90.2 billion of such loans arranged this year.
While Moody’s focus is on institutional term loans, the scoring criteria also assess revolving loans, including both asset-based and cash-flow revolvers, as well as term loan As that are included in the same credit agreement as the institutional term loan, according to the FAQ.
A term loan A is sold mainly to banks. A term loan B is sold mainly to non-bank lenders such as collateralized loan obligations, bank loan mutual funds and hedge funds. In a revolving credit facility, money can be borrowed again once it’s repaid; in a term loan, it can’t.
The ratings company may release scores for a company’s loans as soon as today, Reiss said.
“The idea is to do this on a going-forward basis as credit agreements become publicly available,” Reiss said.
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