Bond Covenants
Key risk areas
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Key risk areas in high-yield bonds
Today we’ll will cover 4 areas in depth with obvious ratings implications
» 1. Distributions / value transfers to other parties
» Risky investments
» 2. Debt incurrence / leveraging
» Change of control (covered in Pt. I)
» 3. Liens subordination risk
» 4. Structural subordination risk
» Long-term bond value
All 4 will, where relevant, show examples of:
» Investor friendly, conservatively structure
» Average – “Market norm”
» Issuer friendly, loosely structured, LBO structure etc.
HY covenant packages in Europe and Americas are substantially the same
But beware of “covenant-lite” bonds
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Distributions / Value Transfers To
Other Parties
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Restricted payments covenant
Risk
» Management has incentive to extract cash and other forms of value to distribute to SHs
and affiliates
» It can do this through various avenues in the corporate structure
» Bondholders are concerned if cash / value transfers at a time when such distributions
decrease the issuer’s debt-servicing capacity
Restricted payments covenant
» Purpose / structure. A company should be able to pay dividends but only if its cash flow
permits after making adequate provision for debt servicing
» Like most negative covenants, the covenant has a three-fold structure:
– (1) Prohibitory paragraph
– (2) Financial ratio tests that are an exception to the prohibitory paragraph
– (3) List of carve-outs
» See RP covenant diagram (handout)
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Debt Incurrence / Leveraging
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Overview
Risk
» Increased leverage can negatively impact bondholders by reducing the cushion of cash
flow, increasing default risk in downturns as well as increasing mgt’s incentive to engage
in shareholder-friendly actions
» In liquidation, additional debt ranking equally with the notes dilutes bondholders’ claims
against a company’s assets
Key covenants & provisions
» Debt incurrence covenant
» EBITDA add-backs
» Debt re-classification clause
» Mergers / “all or substantially all” asset conveyance covenant
» Debt retirement through asset sales proceeds
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Liens subordination risk
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Liens subordination risk
Risk
» Unsecured and secured bondholders do not want other creditors to have prior claims on
assets should the issuer become insolvent
» Additional liens subordination also negatively impacts the market value of their bonds
Key covenants and provisions mitigating this risk
» Negative pledge/limitation on liens
» Sale/leaseback covenant
Secured bonds
» Many permutations in the capital structure involving secured bonds exist
» As to the same collateral, holders are subject to
– dilution risk as to their specific lien position on that collateral
– subordination risk on that collateral, which can occur through a subordinated lien position or
through a “first-out” feature in the proceeds waterfall in favor of another creditor, typically credit
facility lenders
» May be pari passu but “not equal”: enforcement/ control mechanisms can put secured
bondholders at a disadvantage
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Structural subordination risk
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Structural subordination risk comes in many forms
Risk
» Cash flow: bondholders want a direct claim on issuer’s cash flow and its restricted subs
» Assets: in an insolvency, unsecured bondholders do not want to compete with other
unsecured creditors for assets
» Bondholders don’t want more creditors to get ahead of them than they bargained for
Structural subordination can take many forms
» Other claimants get control over the free flow of cash within the restricted group,
restrictions on dividends and superior claims by creditors of subsidiaries
Key covenant & provisions mitigating structural subordination risk
» Debt incurrence ratio test
» Subsidiary guarantee provision
» Refinancing provision
» Application of asset sales proceeds
» Limitation on restriction of dividends by restricted subsidiaries
» Limitations on sale of stock of restricted subsidiaries
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