Do Covenants Provide Real Creditor Protection?

Calculated Risk has access to Fitch research:

The balance of power in the U.S. leveraged loan market continued to shift from creditor to borrower as protective covenant packages declined further during the first five months of 2007...
In nearly any environment, such a radical deterioration in creditor protection would be cause for concern...

I'm interested in this concept of "creditor protection". Intuitively, creditor protection, in the form of covenants or anything else, is likely to increase recovery rates while at the same time increasing default rates – if only because it's much easier to violate one of many covenants than it is to actually miss a coupon payment.

I'd be fascinated to know if any empirical research has been done on this subject: are total returns on covenant-lite loans higher or lower than returns on normal loans with covenants? What does the "protection" of a covenant actually, in practice, protect a creditor against?

Let's say there's a covenant capping the amount that a company could borrow. If a private-equity shop wants to buy the company in question, using lots more leverage, then it will have to pay back the old loans first. In that case, the covenant protects the creditor against a safe loan suddenly becoming an unsafe loan due to the company being sold.

When the company is already owned by a private-equity shop, however, things are different. At that point you're not worried about extra leverage: what you really want is to make sure you get your coupon payments. And the way to do that is to allow the company in question as much freedom as possible to make those payments. In other words, a cov-lite loan could make sense – especially when the numbers in question can reach the tens of billions of dollars, and there would be enormous collective action problems were a creditors' committee ever to form.

So could it be that creditor protections are not ever and always a good idea, from the point of view of lenders?