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What is a covenant lite loan?
A covenant lite loan is a loan agreement that has fewer covenants to protect the lender and fewer restrictions on the borrower regarding payment terms, income requirements and collateral. Covenant lite loans are typically used for leveraged buyouts and other large, sophisticated loan transactions.
Covenant lite loans are riskier than traditional loans. In a typical loan, such as a mortgage, borrowers must meet a variety of requirements before being approved. They must show proof that they can repay the loan and adhere to certain payment terms, among other criteria. But a covenant lite loan, sometimes called a “cov lite,” does not contain requirements that would give a lender warning signs that a borrower is about to default, for example, or that assets are about to deteriorate.
The popularity of covenant lite loans grew as private equity firms and bank syndicates became more powerful and the lending market became more sophisticated. As these financial heavyweights competed for business, they offered less demanding terms to borrowers for leveraged buyouts. Risk in covenant lite loans is spread about through credit derivatives or syndication.
The 2007-2008 financial crisis put the brakes on the use of covenant lite loans, but thanks to low interest rates, the rise in business activity and growing competition in the lending market, covenant lite loans have rebounded.
Covenant lite loan example
Company A needs to raise capital, so it decides to issue bonds rather than borrow from a bank because a bank loan would come with too many restrictions and would be more costly than paying bond investors.
Normally, a legal agreement for issuing bonds would put restrictions on Company A, such as curtailing its ability to take on more debt. But Company A gets a covenant lite bond deal that puts virtually no restrictions or requirements on Company A. One reason Company A was able to get a covenant lite deal is because yields are low, so investors are willing to take on more risk in the quest for higher yields.
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