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Incurrence Covenants for High Yield Bonds

Senior Debt Covenants (Maintenance and Financial Covenants) and Protections

A covenant is a vow – positive covenants or covenants of a positive nature (do not commit fraud, file your financial statements no later than 60 days after the end of a fiscal quarter) commit an obligor to do something. Negative covenants commit an obligor to not do something (do not sell your crown jewel assets).

Term loans (but less so institutional term loans, or term loan B’s) and bank debt generally have maintenance or financial covenants on top of these.

These are a great deal of risk mitigation for the senior secured lenders. A bank is lending money to a company and makes sure that they are within comfort levels (a covenant compliance check from the portfolio management group in corporate banking will occur every quarter).

Senior Debt to EBITDA does not exceed 2x. Debt to EBITDA does not exceed 3x. Interest coverage is above 5x. Debt to capitalization, which the company tried to get a waiver for on the back of share repurchases diminishing Adjusted Shareholders’ Equity, is below 65%.

If the company anticipates going over, they need to explain to the banks to reasonably get a waiver for that quarter only.

If the company breaches, they have to inform lenders immediately and there is a cure period to fix this until an event of default occurs.

Banks are not in the business of losing money, especially when their returns on corporate loans are relatively thin (especially so for undrawn revolvers).

Incurrence Covenants for High Yield Bonds (and Subordinated Debt)

However, high yield bonds are known to be devoid of maintenance covenants. They are lower down the pecking order in terms of payment in a liquidation (before equity, both preferred and common as well as any subordinated or mezzanine debt).

For this reason, high yield bond investors, who have signed up for more risk in return for a much higher yield than bank debt (higher cost of capital), have protections in place known as incurrence covenants. These will be found in the bond indenture for each series – as we must recall that unlike common shares that are more or less fungible, each series of debt (5.5% notes expiring 2024 and 7.375% notes expiring 2029) is different.

Incurrence covenants are tremendously important – practically every commercial ruling in law has defended corporates putting the interests of shareholders above all else. They do not have a fiduciary (have to act in the best interests of) duty to bondholders. As such, bondholders need to make sure that there are enough legal protections in the bond indenture to have comfort.

There are generally a set of incurrence covenants that are standard and will clear the market. Generally speaking, investment bankers will not market bonds that are non-standard without having a very unsophisticated client base. However, in past experience we have seen bonds missing imperative incurrence covenants (for asset sales, so the company could sell all the assets and the bondholders would basically have the credit of a non-existent company… smart) – any high yield bond manager who does not read the covenants or get a lawyer to go through what is missing should not be where people are putting their money.

Common Incurrence Covenants

The common limitations or incurrence covenants are here – with the caveat that

Limitations on Restricted Payments

Basically a negative covenant on paying a dividend, whether to common or preferred shareholders, repurchasing shares or repaying debt that is junior or subordinated to the notes covered by the indenture that has this governor. Of course, this is not a blanket “you cannot do this” – generally speaking, whether a certain amount of cumulative net income or free cash flow generated, monies raised from equity issuance (so paying back what equityholders put in originally) and other allowances will be negotiated.

Limitations on Asset Sales

A bondholder’s probability of getting paid is highly dependent on the assets in the corporation that can service this debt. If a real estate company sold off all of its real estate, there would be nothing to service debt. Accordingly, there are limitations on asset sales – unless they are immaterial or approved by all stakeholders. Additionally, any asset sale generally must have proceeds redeployed for certain causes – otherwise it may trigger an event of default.

These can include purchasing new assets, capital expenditures or debt repayment – things that are ostensibly in the interests of debt service. However, especially with capital expenditures, the new cash flows to interest payments is less certain. As such, the covenant may stipulate that core assets may not be sold in any circumstance.

Limitations on Debt Incurrence

Obviously more debt does not help a bondholder to get repaid at maturity. There may be restrictions on incurring more senior debt (making the liquidation pie smaller for junior bondholders).

Limitations on Merger

Generally speaking, mergers and acquisitions can impair the creditworthiness of the debt. If a corporate is trying to take over another corporate, there are problems in terms of 1) paying cash for the entity (plus any associated debt retirement costs via make-whole or calls for the target company); 2) assuming debt of the entity (which would happen even if it were an all stock transaction).

These can all result in breaches and will need to be approved by bondholders. If a company with high yield bonds is getting acquired, they will generally have a change-of-control put if the new entity is less creditworthy or just let the acquring firm assume the bonds if they are a better credit quality (which boosts the price of the bonds).

Limitations on Liens

Although liens are not debt, per se, liens and guarantees basically create an obligation that rivals debt if anything goes wrong. Accordingly, none of this can be allowed for bondholders.

There is also a bunch of stuff on Restricted Subsidiaries and Unrestricted Subsidiaries that would confuse readers in this simple primer.

Permitted Liens and Baskets

Naturally, as with anything to do with lawyers and corporate lawyers in particular, there are always loopholes that we call permitted ____. Permitted liens, permitted mergers, permitted asset sales – if actions occur in the normal course of business or because of a, b, and c that are clearly defined in the definitions section of the bond indenture, they are permitted without breaching the covenant.

In addition, there are BASKETS. Builder basket, grower basket – loan syndications and leveraged finance bankers throw these terms around all the time. There are certain amounts that you can violate the covenant by that are negotiated by the issuer and the creditors at inception – and these are very important because these allowances can severely impair bondholders from stopping a potentially harmful action if they fall within these limits.

As a simplification, if a $5 billion company has a $4 billion asset sale basket, there essentially is no asset sale basket.

One Dollar Test and Leverage/Fixed Charge Coverage/Debt Service Coverage

All of these covenants generally are breached even if they fall under the permitted umbrella if such action brings the corporate above/below a defined coverage or leverage ratio. So by issuing a permitted distribution the company will go above 4x Debt/EBITDA or below 2x DSCR this will constitute an event of default.

Investment Bankers and Covenants

Investment bankers need to be intimately familiar with these covenants and what the implications are relative to the other debt in the capital structure. Leveraged finance professionals will tell their clients what they can issue additionally given where they are in terms of leverage and how covenants may constrain them.

Restructuring investment bankers representing the debtor (distressed company) will tell them what their options are and are not based on the limitations from the indentures. Restructuring investment bankers representing a certain tranche of debtholders will look at what the limitations are for each stakeholder and try to figure out how they can maximize the recovery for their client accordingly.

Leveraged FinanceLeveraged Finance Debt Capital Markets in Asia · CLOs at the Center of the New PE Industry · Incurrence Covenants for High Yield Bonds · Accessing Leveraged Capital Markets – Part II · Accessing Leveraged Capital Markets – Part I · High Yield Bond Characteristics · What Makes a Good Leveraged Buyout (LBO) Candidate? · What is a Leveraged Buyout? Introduction to LBOs · Introduction to High Yield Bonds · Interview with: Private Debt Analyst · Options for Distressed Debtors: Refinancing and Restructuring · Differences Between Leveraged Finance and DCM · Debt Refinancing Options for Issuers ·

RestructuringIntroduction to Debt Capacity · Distressed Debt Overview · Incurrence Covenants for High Yield Bonds · Options for Distressed Debtors: Selling the Corporate and Bankruptcy · Options for Distressed Debtors: Refinancing and Restructuring · The Restructuring Process for the Distressed Company · Restructuring Group in Investment Banking · Debt Refinancing Options for Issuers ·

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Matt
ex investment banking associate
https://www.linkedin.com/in/matt-walker-ssh/

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