Many investors, even non-professionals, have become adept at judging key ratios of major stock indices, such as the P/E and P/BV ratios. Some investors are also keen enough to follow the Fed, inflation and Treasury yields.

However, the average lay investor has probably not followed the corporate debt market as closely. Aside from its more boring stigma and lack of significant upside potential, many corporate bonds have a minimum investment size that is out of reach for most retail investors.

Even the worst corporate borrowers are surviving

Many companies have managed to survive, only because of the artificially low interest-rate environment that has pervaded in most of the developed Markets in recent years.

This low rate environment brought a "search for yield" sentiment globally and investors became desperate for anything with a positive return.

This means that distressed companies, which might have ordinarily drowned in their accumulated debt, have managed to survive. They have even been able to refinance their debt at interest rates lower than what a distressed borrower would normally be forced to pay.

One would expect that lenders would, at the very least, place appropriate restrictions on corporate borrowers...

except they haven't.

The dangerous return of 'Covenant-Lite' lending

Corporate debt typically comes in two major forms: bonds, which are sold to a wide range of public investors, and leveraged loans, which are mainly bought by banks.

Leveraged loans are ranked higher (i.e., more senior) than junk-rated bonds. Loan providers can often place covenants on debt that restrict the borrowing company from such things as taking on additional debt or placing limitations on the borrower's ability to pay dividends to shareholders.

Prior to the 2007 Great Financial Crisis, there was a spike in loan lending that was considered "covenant lite".

This meant that borrowers had very little restrictions placed on them.

How did this happen? Bonds and loans were then, as today, trading at relatively tight levels and low interest rates encouraged borrowers to leverage themselves higher with more debt.

And demand to invest in positive yielding debt is clearly above supply, meaning that borrowers can get away with more favorable (i.e., less-restrictive) terms.

In fact, according to Moody's, covenant-lite loan lending has reached its worst level ever recorded at the rating agency. Shockingly, Moody's even found that "covenant protections are weakest for lower-rated cov-lite leveraged loans, compounding default and structural risks in certain credits."

This means that a higher amount of corporate debt was raised in 2017 compared to 2007 simply to pay dividends back to the private equity firms that raised the debt in the first place to perform the leveraged buyouts (LBOs).

Why should stock investors care?

Some companies are getting away with more risky, aggressively borrowing more than they normally would. Aside from this being a Warning Signal about the state of the markets, stock investors should be mindful of their place in the company's capital structure.

Being more senior in nature, leveraged loans are typically "secured", or guaranteed on some, or most, of the company's operating assets. The more secured debt there is in a company, the fewer assets would be available for the remaining creditors and shareholders. This means that, in a bankruptcy or liquidation scenario, a company that has a higher amount of secured debt will have a lower amount of remaining value for shareholders, if any.
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