Q. Covenant-light bonds are suddenly very popular… how are they different from typical bonds?
A. Traditionally, bonds have had all sorts of promises — called covenants by the lawyers– designed to ensure the borrower did not get into financial problems that might ultimately lead to a default. So, for example, the bond might not just say “I promise to repay on certain terms” but also: “I promise to never exceed a specified total debt to revenue level”. Cov-lite bonds contain very few, or none, of those sorts of promises.

Q. And you say that we’re seeing a lot hitting the market?
A. That would be a “yes”: $129 billion so far this year, compared to only $22 bn in the same period last year. The troubling thing is that you’re starting to see them in exactly the kinds of deals where covenants have been thought to be so important: loans to companies that already have high leverage: so called “leveraged loans” that are held in a lot of mezzanine debt and credit funds.

Q. So if they provide fewer lender protections, why are they so popular?
A. Once again, the search for yield is distorting a lot of traditional ideas about leverage. Lenders are so desperate to find a place to earn a meaningful rate that they’re competing for these sorts of higher-coupon loans, and they’re doing by saying, OK, so forget the covenants.

Q. And so obviously there’s concern that we’re building this is injecting more risk into these transactions, and into the investment vehicles that hold them.
A. Right, although to be fair the counter-argument that, at least for strong credits, its actually better not to have covenants in a downturn, when the company needs operational flexibility. Cov-lite loans didn’t really perform worse than other loans in the last downturn, although that’s probably because they had been prmiarly made to strong credits in the first place. But the sheer volume is telling you that not all these loans are in fact going to strong credits. And, yes, that’s worrisonme.