High-yield bonds are usually fixed rate instruments with “bullet” maturities (ie, the full outstanding principal amount matures at once on the final maturity date), and the typical tenor ranges between eight and ten years. A given high-yield bond offering can range in size from $150 million to upwards of $1 billion in aggregate principal amount and the “coupon”, or applicable interest rate, typically ranges from seven per cent to 11 per cent, depending on the industry, the issuer’s credit rating, leverage profile, historical financial performance and the deal structure (eg, whether secured or not). It is common for a given high-yield bond offering to include multiple series of bonds denominated in different currencies and with different tenors. Interest payments are typically required to be paid on a semi-annual basis.
Listed, widely distributed, with an active secondary market
High-yield bonds are usually listed on a stock exchange, though this is done primarily for tax reasons rather than to enhance liquidity and it is atypical for the listing to be on the issuer’s home stock exchange. For European issuers the listing is often on the Luxembourg stock exchange. A high-yield bond offering is generally marketed to an investor base consisting of several hundred institutional investors, including hedge funds, high-yield funds, corporate funds, insurance companies and pension funds, and once issued they are generally actively traded in the secondary market. A significant proportion of investor demand can be expected to come from the US high-yield investor community. Secondary trading in high-yield bonds takes place “over-the-counter” and clearance and settlement takes place through the various clearing systems.
Subordination and other structural characteristics
The classic high-yield bond instrument is subordinated debt; that is, it is subordinated in right of payment to the issuer’s senior bank financing. Subordination can be accomplished by several means, including structural, contractual or effective subordination. High-yield bonds typically benefit from guarantees from other entities within the corporate group in support of the credit. High-yield bonds are typically not secured by security interests over real property of the issuer or its corporate family, although the US and European high-yield markets are seeing an increasing number of transactions structured as fully secured deals, with the bonds benefiting from the same security package as the senior bank lenders. This trend of high-yield bonds to be fully secured appears to be developing for the most part in the context of refinancing transactions where bonds are issued in order to refinance existing bank debt in full or in part. In all contexts, however, it is customary for high-yield bonds to at least benefit from limited security, including share pledges over the issuer and pledges of repayment rights under intercompany loans used to on-lend the bond proceeds down into the corporate group.
The covenant package
High-yield bonds have developed a reputation for being complex instruments, notorious in particular for their complicated covenant packages which non-practitioners find difficult to understand. While this characterisation may not be undeserved, it is important for finance officers to appreciate that, although high-yield covenants may be complicated and highly technical, they are on the whole less restrictive and more “user friendly” than covenants contained in typical senior bank loan facilities. This is because high-yield bond covenants are “incurrence” based rather than “maintenance” covenants. An “incurrence” covenant is only tested when the issuer takes a voluntary action, for example, where it incurs additional debt or sells an asset; whereas a “maintenance” covenant is tested on predetermined dates (eg, quarterly or semi-annually). The distinction between “incurrence” and “maintenance” covenants is discussed in more detail below.
High-yield bond covenants are designed to protect bond investors from a somewhat unique set of concerns, borne of the fact that other tiers of an issuer’s capital structure will have divergent and competing rights and interests. For example, a company’s equity holders may be incentivised to leverage up the company so long as it maximises shareholder value, or dividend or otherwise take cash out of the company. A company’s senior bank lenders, on the other hand, will want to minimise repayment risk and to that end are likely to be secured and to benefit from maintenance covenants which, to a degree, effectively dictate the manner in which the company operates its business. High-yield bond covenants are designed to maintain the bonds’ relative payment priority, protect against loss of equity cushion (in an insolvency scenario, equity ranks lower than debt) and otherwise prevent credit deterioration (through controls over asset and cash leakage), but without restraining a company’s ability to grow, because positive growth will enhance the capital value of the bonds which benefits bond trading prices in the secondary market.
The following covenants comprise the customary high-yield bond covenant package:
- Limitation on Indebtedness and Issuance of Preferred Stock (the “Debt covenant”). This covenant restricts future debt incurrence capacity, and certain preferred equity issuances, against a negotiated coverage or leverage ratio, and permits debt incurrence and equity issuance of certain categories and amounts as set forth in negotiated carveouts.
- Restricted Payments. This covenant limits dividends, equity and subordinated debt repurchases and certain restricted investments against a negotiated formula, and permits certain other agreed categories of payments and investments.
- Dividend and Other Payment Restrictions Affecting Subsidiaries. This covenant limits upstream payment blockages in order to ensure that cash necessary to fund interest and other payments on the bonds is not trapped in the corporate group below the issuer of bonds.
- Merger, Consolidation or Sale of Assets. This covenant permits fundamental corporate transactions, but only if key tests are satisfied.
- Transactions with Affiliates. This covenant limits transactions with affiliates outside the credit group, eg, equity sponsors and “unrestricted” subsidiaries.
- Limitations on Liens. This covenant prevents effective subordination of bondholders that could result from the company granting additional security. This covenant is often heavily negotiated and very broad carveouts are typical in contractually and structurally subordinated deals.
- Sale and Leaseback Transactions. This covenant limits sale and leaseback transactions (capital leases are usually covered by the Debt covenant).
- Limitation on Issuance and Sales of Equity Interests in Wholly-Owned Subsidiaries. This covenant limits partial sales of “restricted” subsidiaries; it can block partial spin-offs.
- Limitations on Issuance of Guarantees of Indebtedness. This covenant requires that the bondholders benefit from pari passu guarantees where group “restricted” subsidiaries provide guarantees of other debt, in order to limit effective subordination.
- Business Activities. This covenant requires that the company limit its business operations to certain agreed lines of business (commonly referred to as the “stick to knitting” covenant).
- Anti-layering covenant. This covenant prohibits the company from incurring new subordinated debt unless that debt is also subordinated to the bonds. The covenant ensures that the high-yield bonds do not become subordinated (or further subordinated, as the case may be) to new debt incurred.
It is important to note that while these covenants are part of the standard high-yield bond covenant package, the standard covenant package is prone to modification depending on the market in question. For example, high-yield bonds issued by companies based in an emerging market country are likely to include significant variations from the standard package.
In most high-yield deals, the two most important covenants are the Debt covenant and the Restricted Payments covenant. These are discussed in more detail below.
The Debt covenant
The basic Debt covenant is designed to maintain a minimum level of financial health of the issuer by restricting its ability to incur additional debt. In some cases, the basic covenant requires that the issuer’s financial health improve in order for it to incur additional debt, for example by providing that the applicable ratio test becomes more restrictive (or “steps up”) after the first year or two.
Debt incurrence tests utilise two main varieties of debt ratio, a fixed charge coverage ratio (which measures EBITDA against interest expense) or a leverage ratio (which measures debt to EBITDA). The Debt covenant is an “incurrence” based covenant, which is only tested in the event that the issuer incurs additional debt. Because both variations of the debt test are formulated as ratios, they allow the issuer to incur more debt as its credit quality improves, in proportion to its ability to cover interest expense.
Defining what adjustments the issuer is permitted to make in calculating EBITDA and interest expense, and what counts as debt, for purposes of compliance with the Debt covenant are often the subject of focussed negotiations among the deal parties. Typical adjustments to EBITDA include pro forma adjustments for acquisitions and divestitures as if they had occurred at the beginning of the test period in question, and adjustments that eliminate the impact of “extraordinary” items.
All debt covenants include a concept of “permitted debt”. Categories of debt that fall within this definition can be incurred irrespective of whether the applicable debt ratio would be satisfied. “Permitted debt” will often include existing bank debt, debt incurred in the ordinary course of business, categories of debt that fall within negotiated “baskets” tailored to the specific issuer and the industry in which it operates up to agreed capped amounts and a general debt basket that can be used for unspecified purposes, again up to a capped amount.
The Restricted Payments covenant
This covenant prohibits the company from paying cash dividends on its common or preferred shares or from repurchasing such shares, prohibits repurchases of debt securities that are subordinate to the bonds and restricts investments, except to the extent permitted by a strict financial test that requires credit improvement over the life of the bonds. The restricted payments test is designed to protect the bondholders’ so-called “equity cushion” by limiting the ability of asset classes that rank beneath the bonds in the issuer’s capital structure, in terms of priority of payment and in the insolvency scenario, to “cash out” in advance of the high-yield bonds and by otherwise trapping cash in the company. The basic test prohibits all such payments or transfers (known as “restricted payments”) unless (a) total restricted payments are less than 50 per cent of the issuer’s consolidated net income from the time the bonds were issued, (b) the issuer could incur $1 of additional debt at the time the contemplated restricted payment is to be made and (c) no default exists.
Customary exceptions to the Restricted Payments covenant include investments made in the ordinary course of business, payments to “restricted” subsidiaries within the corporate group, limited repurchases of equity from current or former management (subject to an annual cap), application of new equity proceeds to immediately purchase outstanding equity or to make a restricted investment, a general basket that can be used to make any type of restricted payment subject to an overall cap, and specified permitted investments, typically subject to a dollar cap or limited to a percentage of total assets.
“Restricted” and “Unrestricted” subsidiaries
Naturally the issuer of the bonds will be subject to the bond covenants. However, the covenants will also apply to the issuer’s subsidiaries, though not necessarily all of them. The covenants will only apply to the issuer’s so-called “restricted” subsidiaries. The issuer determines which of its subsidiaries are to be “restricted” or “unrestricted” subsidiaries, although in practice all of the issuer’s material operating subsidiaries will form part of the “restricted” subsidiaries group, and will also provide upstream guarantees. This is because the covenants severely limit the transactions, including the flow of cash and intra-group mergers, that can take place among the issuer and its “restricted” subsidiaries, on the one hand, and with “unrestricted” subsidiaries, on the other. The issuer’s “unrestricted” subsidiaries will for purposes of the bond covenants be treated almost as if they are third parties rather than part of the issuer’s group.
Incurrence versus Maintenance covenants
It is important to re-emphasise why issuers consider high-yield covenants to be a particularly attractive feature of the product. High-yield covenants are “incurrence” based, meaning that most of the covenants are only tested when the company takes an affirmative action, such as incurring additional debt or making a restricted payment. This is in contrast to “maintenance” financial covenants standard in bank loan agreements, which are automatically tested on predetermined dates and as such require the borrower to maintain an agreed level of financial health from period to period. As such, the core financial restrictions in any loan transaction, namely, the debt covenants (and related test ratios), takes a less restrictive form in a high-yield bond than in a senior bank loan. Issuers often consider high-yield covenants to be more “user friendly” than comparable covenants in senior bank loans because the issuer has a higher degree of control over when the covenants are tested.
Other standard provisions
Other standard provisions customary to high-yield bonds include the following:
- Bondholder put rights. The put rights give bondholders the option to require the issuer to repurchase bonds (i) in the event of a change of control of the issuer (the change of control put is sometimes tied to a ratings downgrade) at 101 per cent of the principal amount of the bonds outstanding or (ii) upon certain asset sales, such as where asset sale proceeds are not reinvested in the business or used to repay senior debt.
- Issuer’s optional redemption right. High-yield bonds typically allow the issuer to redeem the bonds at a premium. However, issuers are normally prohibited from exercising their redemption right for a prescribed period of time, referred to as the “no call” period, which typically extends three to five years from the date of issuance. This “no call” feature helps to ensure that investors realise some return on their investment. A typical exception to the “no call” prohibition”, known as an “equity claw back” provision, permits the issuer to redeem a certain proportion of bonds (for example, 35 per cent of the aggregate principal amount of the bonds) during the “no call” period with the proceeds from the issuance or sale of equity.
- Issuer’s redemption right for taxation reason. This right is available in the event that a change in law results in a requirement for the issuer to make withholding or other tax gross-up payments.
- Events of default. These cover the customary scope of default scenarios, but importantly the cross-default provisions are typically either cross-acceleration or cross-payment defaults, in contrast to customary senior bank financing terms which contain cross-default provisions that are triggered by any default under other debt (giving senior banks stronger protections).
- Financial statements. Financial statements are typically required to be provided on a semi-annual and annual basis, but sometimes on a quarterly basis, depending on the credit quality of the issuer.
- Additional Amounts provisions. These are tax gross-up provision that requires gross-up payments if withholding tax is imposed on interest payments on the bonds.
- Legal defeasance and covenant defeasance. These provisions allow the issuer to effectively no longer be subject to the bond covenants and other provisions where it prepays into trust an amount that will cover the full amount of interest, principal and/or premium amounts payable over the remaining life of the bonds. Full legal defeasance cannot presently be achieved because required tax opinions are unobtainable.
- Satisfaction and Discharge. This provision allows the issuer to prepay into a trust all amounts payable within one year of maturity of the bonds and thereby satisfy and discharge all obligations under the bonds.
- Amendment, Supplement and Waiver. These provisions set forth requirements for obtaining bondholder or trustee consent to various actions, and identifies certain limited amendments to be effected without consent.
Variations on a theme
Other bond instruments which have developed from the high-yield bond blueprint, and which tend to increase and decrease in popularity depending on the point in the market cycle, include mezzanine notes, second lien notes and holdco pay-in-kind (PIK) notes.