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Module 7 Quiz Answer Key

The leveraged loan market is valued at approximately $1-2 trillion, while the high-yield bond market is around $3-3.5 trillion. Distressed direct lenders prefer maintenance covenants for better control over borrowers, and the largest buyers of leveraged loans are CLOs, which structure loans into tranches based on risk. Private equity firms favor leveraged loans over high-yield bonds due to lower costs and fewer restrictions, while the shadow banking market grows due to the search for returns, capital demand from lower-rated companies, and the flexibility of unregulated credit agreements.

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16 views

Module 7 Quiz Answer Key

The leveraged loan market is valued at approximately $1-2 trillion, while the high-yield bond market is around $3-3.5 trillion. Distressed direct lenders prefer maintenance covenants for better control over borrowers, and the largest buyers of leveraged loans are CLOs, which structure loans into tranches based on risk. Private equity firms favor leveraged loans over high-yield bonds due to lower costs and fewer restrictions, while the shadow banking market grows due to the search for returns, capital demand from lower-rated companies, and the flexibility of unregulated credit agreements.

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aliceee.376
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© © All Rights Reserved
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Module 7 Quiz Answer Key

1) What is the size of the leveraged loan market? What is the size of the HY bond market?
The leveraged loan market is approximately $1-2 Trillion and the HY bond market is
approximately $3-3.5 Trillion.
2) Why would a distressed direct lender prefer maintenance covenants versus incurrence
covenants in its loan documentation?

Maintenance covenants allow for direct ongoing control by the lender of the borrower.
The borrower at all times has to prove that they are in compliance with the covenant.
Incurrence covenants do not. As long as there is no default, there is no course of action
an incurrence covenanted lender can pursue should a problem arise with the borrower
that puts the lender’s investment at risk. As such, a credit agreement with maintenance
covenants allows a lender to lend to a riskier borrower while maintaining greater
control of the borrower’s actions, thereby lowering the lender’s risk on a relative basis.
All bi-lateral lending agreements to poorly rated borrowers have maintenance
covenants as a result.

3) What is the largest buyer of non-investment grade loans, otherwise known as leveraged
loans? Describe or draw the mechanism of how it works?
The largest buyers of leveraged loans are Collateralized Loan Obligation Funds, or CLO’s.
CLO’s are a structured vehicle and as such are put together with a similar structure to
other structured vehicles such as Collateralized Mortgage Backed Securities (CMBS),
Asset Backed Securities (ABS), etc. The vehicle purchases loans across a distribution of
ratings and industries to achieve an acceptable overall probability of default based on
150 years of default data per industry/rating which is maintained by the Rating
Agencies. Different tranches of fixed rate securities are then issued into the market and
provide the capital to the CLO to purchase the loans. Those securities are rated based
on their ranking as to loss should there be defaults in the vehicle. The first loss security
is the equity and the last loss security is rated AAA. Tranches of BBB, BB and B securities
are also issued based on their relative loss positions. To repeat, each rated security that
is funding the CLO achieves its rating based on the probability of default for the loans in
the CLO and the relative loss position of the security should there be defaults of the
loans in the vehicle. Given a CLO’s cost of capital, they are generally precluded from
buying investment grade loans as the returns on those loans do not support the cost of
funding for the CLO. There are some exceptions for low rated investment grade loans
where even though the return is too low for the CLO, the improvement on the overall
probability of default that the low rated IG loan gives to the CLO loan portfolio offsets
that detriment. It creates more capacity for the CLO to buy lower rated loans with
higher returns. This is because the probability of default is not linear to the rating of a
loan. The probability of default increases at a faster rate than the relative decline in the
rating.
See attached drawing of a CLO for more information.

4) Why do Private Equity Firms, otherwise known as Sponsors, prefer leveraged loans to
HY bonds?

Leveraged loans have no call provisions and are cheaper to arrange than HY bonds
(175bps gross spread for leveraged loans versus 250 bps gross spread for HY bonds).
They sometimes have a repayment premium of 25-50 bps for up to a year to protect
them against repricing should interest rates decline (remember these are floating rate
instruments that directly reflect changes in interest rates). They are prepayable at par
in a refinancing. HY Bonds, on the other hand, have make-wholes and call provisions
that protect the investor in case of a refinancing. This is because they are a fixed rate
instrument and investors are exposed to changes in interest rates (remember bond
math?) and this is what investors require to take that interest rate risk. Since a
company’s balance sheet which is owned by a PE firm is in a constant state of flux due to
monetizations by the PE firm, leveraged loans are a much lower cost option than bonds.
If the PE firm refinances the balance sheet, sells the company, needs an amendment,
etc., all of those activities are cheaper to execute with loans versus bonds give the lack
of these call provisions. The cost of those refinancings comes directly out of LPs’
investments in the PE fund and reduces the fund’s returns. Loans are cheaper and have
a smaller negative impact on the PE fund’s returns. Hence the preference for loans by
PE firms.

5) What are three of the major drivers in the development and growth of the Shadow
Banking market?
1) A constant search for returns by investors in a low interest rate environment.
2) The demand for capital by lower rated companies.
3) The unregulated aspects of the market allow for more creativity and control on the
part of investors. Credit agreements can be customized based on specific
requirements, eg., maintenance versus incurrence covenants as warranted, etc.

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