Covenant Quality and Protections

Difficulty: Intermediate Published: 2025-12-29

Covenant-lite loans now represent 91% of outstanding US leveraged loans ($1.29 trillion)—a structural shift that trades 25-50 bps of yield for 10-15 cents lower recovery when defaults occur. The erosion happened gradually, then all at once: from 17% cov-lite share in 2007 to 93% of new issuance by 2024.

What Covenant Erosion Costs You

The math is uncomfortable. S&P Global documented that covenant-lite first-lien loans recover 57-61% in default versus 66-72% for covenanted loans—a 9-11 percentage point gap that translates to real money.

On a $10 million position that defaults:

• Covenanted loan recovery: $6.6-7.2 million
• Covenant-lite loan recovery: $5.7-6.1 million
• Your loss differential: $900,000-$1.1 million

The yield pickup for accepting weaker covenants? Essentially zero. The historical 50-75 bps premium that cov-lite loans once commanded has vanished (Griffin, Nini & Smith, 2018). Lenders accepted structurally lower recoveries without demanding compensation.

(This asymmetry—same yield, worse recovery—explains why covenant analysis matters more than spread analysis for leveraged credit.)

Source: S&P Global Ratings, 2023. First-lien term loan recovery study covering 2010-2023 defaults.

How Covenants Actually Protect You

Covenants function as early warning systems and control mechanisms. When a borrower's credit deteriorates, strong covenants force action before the situation becomes terminal.

Maintenance Covenants (The Quarterly Check-Up)

Maintenance covenants require borrowers to meet financial tests every quarter, regardless of what actions they take.

Example maintenance covenant package:

• Maximum leverage: Debt/EBITDA cannot exceed 5.0x
• Minimum interest coverage: EBITDA/Interest must stay above 2.0x
• Minimum fixed charge coverage: (EBITDA - CapEx) / Fixed Charges above 1.25x

When violated: The borrower enters technical default, shifting negotiating power to lenders. Options include repricing the loan (higher spread), tightening terms, or accelerating repayment.

(Maintenance covenants matter because they catch problems quarterly—before the borrower burns through remaining liquidity.)

Incurrence Covenants (The Transaction Gate)

Incurrence covenants only trigger when borrowers attempt specific actions. They prevent value leakage but don't provide ongoing monitoring.

Key incurrence tests:

The problem: A company with 6.0x leverage that does nothing violates zero incurrence covenants. The loan continues current while the credit deteriorates.

Source: Simpson Thacher, Leveraged Finance Covenant Handbook, 2024.

The Cov-Lite Problem: A Worked Example

Scenario: Two identical $500 million loans to companies with 5.5x leverage

Company A (Full Covenant Package)

• Maintenance: Max leverage 5.0x tested quarterly
• Current leverage: 5.5x (already in violation)
• Consequence: Technical default triggers immediately
• Lender options: Reprice to SOFR +450 bps (from +350), require $50M paydown, tighten EBITDA add-backs

Company B (Covenant-Lite)

• Incurrence only: Cannot incur additional debt above 6.0x
• Current leverage: 5.5x (no violation)
• Consequence: Loan continues current at original spread
• Reality: Company has 18 months of runway to either recover or deteriorate further

Fast forward 12 months—EBITDA declines 20%:

Company A: Already restructured. Lenders received additional 100 bps spread for 12 months ($500M x 1% = $5M extra interest), plus principal paydown.

Company B: Leverage now 6.9x. Still no covenant violation (no actions taken). Value has eroded significantly. When default finally occurs, recovery drops from projected 65% to 52% due to delayed intervention.

Recovery impact on $500M position:

• Company A (early intervention): $325 million recovery (65%)
• Company B (no early warning): $260 million recovery (52%)
• Cov-lite cost: $65 million in lost recovery

(The cov-lite structure didn't cause the credit deterioration—it just prevented lenders from responding until too late.)

The J.Crew Trap Door: Covenant Loopholes in Action

In 2016, J.Crew demonstrated exactly how creative borrowers exploit covenant gaps.

The setup: J.Crew had $1.57 billion in secured term loans and deteriorating retail operations.

The loophole: The credit agreement allowed transfers to unrestricted subsidiaries under certain conditions. Crucially, the term "proceeds" remained undefined.

The execution:

1. J.Crew designated a new unrestricted subsidiary
2. Transferred $250 million of intellectual property (brand trademarks) to this subsidiary
3. Argued the IP constituted "proceeds" of an earlier investment—circular logic that technically complied
4. Used the IP as collateral for new debt, proceeds went to pay down PIK notes (junior to the term loan)

The result: Secured lenders lost $250 million of collateral protection. They filed suit, eventually settling for partial paydown at par and covenant tightening.

(J.Crew's "trap door" spawned an entire category of "J.Crew blocker" provisions—but covenant analysts note most blockers only partially close the gap.)

Similar transactions followed at iHeart Communications, Revlon, and Claire's Stores.

Source: Yale Law Journal Forum, 2022. Analysis of liability management transactions.

Reading Covenant Quality: Red Flags and Protections

Strong covenant indicators (better protection):

-> Maintenance covenants present with quarterly testing -> EBITDA add-backs capped at 15-20% of pro forma EBITDA -> Restricted payment baskets linked to leverage tests (blocked above 4.0x) -> J.Crew blocker preventing material asset transfers to unrestricted subsidiaries -> Asset sale covenant requiring 100% net proceeds to debt repayment -> Change of control put at 101% of par

Weak covenant indicators (lower recovery expected):

-> Incurrence-only with no maintenance testing -> Uncapped EBITDA adjustments (allows creative accounting) -> Large "general" baskets for restricted payments ($50M+ or 1%+ of assets) -> Extended reinvestment periods (24+ months to deploy asset sale proceeds) -> Loose unrestricted subsidiary criteria (easy to designate and move assets) -> No J.Crew blocker or partial protection only

Spread Implications: What Covenant Quality Should Cost

Historical context: Pre-2015, covenant-lite loans traded 50-75 bps wider than covenanted equivalents (Moody's, 2015).

Current reality: The premium has compressed to near zero. Demand from CLOs and loan funds created a buyer's market for borrowers.

What the math says you should demand:

Break-even calculation: If you assume 3% annual default probability and a 10-point recovery differential, the covenant quality costs 30 bps annually (3% x 10% = 0.30%). The market currently charges approximately zero.

(This mispricing persists because covenant analysis requires legal expertise that most credit analysts lack—and CLO managers get paid on spread, not recovery.)

Implementation Checklist

Before buying leveraged loans or high-yield bonds:

Step 1: Identify covenant type -> Request credit agreement or indenture summary -> Classify as maintenance, incurrence-only, or cov-lite -> Note testing frequency and specific ratios

Step 2: Assess EBITDA definitions -> Identify permitted add-backs (cost savings, synergies, pro forma adjustments) -> Check for caps on adjustments (15-20% is tight, uncapped is concerning) -> Calculate "true" leverage using reported vs adjusted EBITDA

Step 3: Evaluate leakage risk -> Size restricted payment baskets (smaller is better) -> Check unrestricted subsidiary designation criteria -> Look for J.Crew blocker provisions

Step 4: Adjust recovery assumptions -> Strong covenants: Use 65-72% first-lien recovery -> Weak covenants: Use 55-62% first-lien recovery -> Factor recovery difference into spread requirements

Step 5: Monitor ongoing -> Track covenant headroom in quarterly filings -> Watch for amendment requests (often signal stress) -> Note any unrestricted subsidiary activity

Covenant quality determines whether you negotiate from strength when credits deteriorate—or discover the damage after recovery value has eroded. The 9-11 point recovery differential between covenanted and cov-lite loans represents real money: on a diversified leveraged loan portfolio with 4% defaults, weak covenants cost 40 bps annually in expected loss differential. Demand compensation accordingly.