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Credit markets have short memory
Tighter, then looser
Credit tightened hard after the global financial crisis of 2007 to 2009. At the same time, the lenders behind corporate debt shifted toward alternative asset managers, hedge funds, institutional investors, and private credit, firms that in the past might have been bond investors. As a result, covenants on loans and bonds began to converge.
Limits that gave way
The limits that borrowers had once been held to loosened again. Rules against taking on more debt, granting more liens, making restricted payments, or doing affiliate transactions gave more room, and a lot of the loans made in that looser stretch can never be repaid.
Bond habits in loans
Lenders who thought like bondholders were also used to selling debt back to the borrower at a discount or offering an exit consent, a way to help the borrower and themselves at once. The lines between what a bond indenture allows and what a term loan should allow blurred.
Why did loan covenants start to look like bond covenants?
Investors that once bought bonds moved into the loan market, and they brought bond-style terms with them. Covenant-lite loans, which carry fewer ongoing financial tests, became a majority of the U.S. leveraged loan market in the years after the crisis, according to data from LCD, a loan market data provider. Strong demand for loans let borrowers ask for fewer restrictions. The result was loan agreements with limits closer to those in a bond indenture.
How did private credit grow after the crisis?
Post-crisis banking rules, including Basel III and the 2013 interagency leveraged lending guidance from the Federal Reserve, OCC, and FDIC, made it costlier for banks to hold risky loans. Nonbank lenders such as asset managers and private credit funds filled the gap. These lenders raise money from institutions and lend to companies directly. The private credit market grew from a niche into a large source of corporate financing over the following decade.
Why do lenders loosen terms when money is plentiful?
When many lenders chase a limited number of deals, borrowers and their sponsors can ask for looser terms, and a lender that refuses may lose the deal. The Federal Reserve's Senior Loan Officer Opinion Survey tracks this pattern, asking banks each quarter whether lending standards are tightening or easing. Standards have tended to ease when demand for loans is strong and tighten after losses. The cycle repeats because each period of losses fades from the memory of lenders.