Wednesday 03 April 2019 by Thomas Jacquot General

Covenants and security, here to protect noteholders

In our view, covenants are one of the most important protections for investors in high yield bonds as they ensure that issuers will operate within relatively tight boundaries so that credit quality is at least maintained at certain levels and, in some cases, improved over the life of the bonds. A breach of a covenant should, in most instances, be an opportunity for the company and its creditors to enter into a dialogue and implement a remedial plan well before the solvency of the company is at risk.

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What are covenants?

In simple terms, covenants are commitments that an issuer provides for the benefit of its debt investors. We generally see three types of covenants:

  • Positive covenants: these are actions that an issuer has to positively pursue. This includes obligations such as maintaining certain levels of insurance, ensuring permits and licenses remain in full force and effect or providing regular information. The purpose of positive covenants is to ensure that an issuer will operate in a certain manner consistent with investors’ expectations.
  • Negative covenants: these are actions that an issuer should never do. For example, an issuer might be prevented from selling certain assets or undertaking different lines of businesses.
  • Financial covenants: these are ratio-based tests that an issuer needs to maintain on a regular basis. The frequency of testing will vary from once every quarter or year, to only when new debt is being raised.

     

Investment grade securities

Investment grade securities are generally seen by bond investors as relatively low risk because the investment grade rating is synonymous with strong business fundamentals and low leverage. This underlying stability translates to a default being extremely rare (but not necessarily unheard of). Another reason for the low breach rate is that these securities are issued with very few to no covenants. In other words, investors trust that investment grade companies can run their businesses without the scrutiny of having to comply with covenants. Based on historical data from S&P Global Ratings, companies with the lowest possible investment grade rating have a 2.84% probability of defaulting over a five-year period.

Structures for high yield debt issues

Debt issuances in the high yield and unrated markets are structured materially differently because their distance to default is inherently shorter than for investment grade issuers. In effect, the default probability for high yield bonds is much higher. In the same study, S&P Global Ratings estimate that the default probability for an issuer rated BB- over the same five-year time horizon is 9.66%, rising to 26.18% for an issuer rated B-, almost ten times higher than the lowest investment grade bonds.

Structuring a bond issue for a high-yield or unrated issuer is fundamentally very different than for an investment grade issuer. In these cases, it is not possible to simply rely on the very long distance to default. For these bonds, the focus is on catching any early credit weakening and ensuring this is remedied well before the issuer has suffered significant value deterioration. If you think about the proverbial “catching a falling knife”, for an investment grade bond, you are dropping the knife from a very high altitude but you are relying solely on the issuer to stop the fall. For a high yield bond, you need to catch the knife as soon as it starts slipping out of your hand. This is why covenants are critical.

Many people see a covenant breach as akin to a payment default. While, according to the typical bond terms and conditions, a breach of covenant, if unremedied, would eventually lead to a default, it is extremely rare that a covenant breach immediately leads to a payment default and loss of capital. In practice, we see a covenant breach as an early warning signal that an issuer is simply not performing in line with expectations and not necessarily that an issuer is in distress.

If we look at recent FIIG arranged debt issuances, the recently launched Armour Energy bond has a comprehensive set of covenants which reflects the current position of the company. We list below the key covenants and why they have been included in the documentation and the reason for their presence:

Debt Service Cover Ratio
Tests the ongoing ability to pay debt service
Gearing ratioEnsures the company maintains sufficient equity
Cash balance
Maintains ongoing liquidity
Dividend restriction
Limits cash leakage
Minimum reservesMaintains enterprise value
Minimum contract revenueProvides greater cash flow predictability

All of these covenants are designed to ensure that, in the event of a breach, noteholders have an ability to influence what step the company will take to return to compliance. These are used as early warnings when there remains significant value in the company and, should noteholders elect to exercise their rights and take action in the event of a covenant breach, they will be in a much stronger position to extract the maximum value to support the return of their capital because, while a breach might be outstanding, there would not otherwise be any immediate risk of bankruptcy.

Benefit of security

Another important consideration in the structuring of a high yield or unrated bond is the security structure, i.e. where the bond ranks in the payment priority waterfall in the event of a default. The vast majority of bonds in the high yield sector are secured, either on a senior or subordinated basis.

Investment grade bonds are typically unsecured because the crux of the investment is the very low default probability. Investment grade issuers are generally reluctant to provide security as it usually places restrictions on their ability to deal with their assets.

For high yield/unrated issuers, bond investors are keen to maximise their position in the payment waterfall as it will significantly improve their potential recovery in the event of a default. This is because secured creditors have, under the Corporations Act, a protected position and have access to certain rights not otherwise available to unsecured creditors. In particular, if a company appoints a voluntary administrator (who would act in the interest of all creditors), secured creditors (who hold security over all or substantially all of an issuer’s assets) have the ability to appoint a receiver who will act solely in their interest and will be able to dictate proceedings ahead of the voluntary administrator.

Many FIIG-arranged bonds are subordinated in the payment waterfall but still benefit from security over the issuer’s assets. This is the case in recent issues such as Maurice Blackburn or Zenith Energy. Secured subordinated noteholders do not share the same rights as senior secured lenders since they are typically prevented from taking any affirmative action immediately upon a default occurring, instead allowing for senior secured creditors to act first.

This is still a significantly better position when compared to unsecured debt investors in a structure which also incorporates secured debt. It is common to see very strict restrictions applied to unsecured creditors in those structures.

Conclusion

In our view, comprehensive covenant packages and strong security positions are critical for investment in many high yield bonds. While covenant breaches often trigger a negative sentiment among investors, it is important to remember that these are structured to protect noteholders’ interests and an appropriately structured covenant will ‘bite’ early enough so that the issuer continues to have significant value.

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