Wednesday 12 June 2019 by Jessica Rusit Education (advanced)

Understanding Covenants

Covenants are a key line of defence for bondholders, especially when investing in unrated or sub investment grade bonds. They act to align the interests of both the issuer and the bondholders and serve as a layer of protection well ahead of any potential payment default. Here we look at the different covenants and how they work.

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What is a covenant?

Covenants are contractually binding terms and conditions the issuer must adhere to and satisfy throughout the bond’s tenor. They are prescribed in the official documents at time of issuance, and ensure the issuer operates in a financially prudent manner.

Covenants exist to better align the goals of both issuers and bondholders. They are used as an early warning signal, allowing bondholders to take action and mitigate the probability of a payment default ahead of any potential deterioration in credit quality of an issuer.

Shareholders aren’t provided a similar safety net, and usually the first sign of credit weakness will result in a drop in share price, and potentially a cut to dividend payments. Bondholders however, will generally still receive coupon and principal repayments and are a part of the remedy process.

How do covenants work?

There are different types of covenants, which include financial and non-financial metrics, and bond documents, such as the Information Memorandum, which stipulate the measures and framework an issuer must abide by. A breach of these metrics can trigger a technical default.

A technical default refers to the issuer not operating within the agreed terms and conditions, while generally still making regular coupon and principal payments. The issuer must then rectify the breach in a timely manner, which usually involves a dialogue with its creditors to agree on a remediation plan well before the solvency of the issuer is at risk.

Covenants play more of a vital role when investing in sub investment grade or unrated bonds, as those bonds have a higher chance of default compared to investment grade bonds. Investment grade bonds are generally considered to be lower risk, as the rating infers strong business fundamentals and lower leverage. The sooner any credit weakness in sub investment grade or unrated bonds is detected, the faster a resolution can be implemented prior to suffering any significant value deterioration.

Understanding the types of covenants in place can give an investor peace of mind and also make certain fixed income investments more appealing.

Types of covenants

The different types of covenants all act as check points in ensuring the issuer is operating consistently with bondholders’ expectations. Financial covenants are ratio-based tests that an issuer needs to maintain on a regular basis. Meanwhile non-financial covenants are restrictions and limitations that aren’t determined by a financial benchmark.

Each financial covenant serves a purpose in ensuring either the leverage, serviceability or recovery is met and maintained to protect bondholders. In the following table we provide some examples:

Financial covenants

Type

Example

Purpose/Description

Leverage

Debt to EBITDA

Debt to Capital

These ratios provide an immediate and simple indication of debt level for a given company. The higher the value, the higher debt levels are, which indicate a greater level of risk.

While these measures provide easy ways to compare two companies, it is important to also think about these measures in the context of the industry the company is operating in. For example, a debt to EBITDA ratio of about 6x would be seen as high (and therefore indicative of higher risks) for industrial companies, yet is a level usually seen for investment grade companies in the infrastructure sector. This is because of the inherently higher cash flow predictability.

 

Serviceability

Interest Cover

Debt Service Cover

Fixed Charge Cover

Unlike leverage ratios that provide an indication of overall debt level, coverage ratios focus on the ongoing serviceability of a company’s debt payments. These ratios are typically looking at earnings or cash flow over a defined period and compare those to the company’s debt obligations (interest and debt repayment). A high number indicates that a company has a significant buffer against potential cash flow shortfall, hence a debt non-payment would be unlikely.

Unlike a leverage ratio, a coverage ratio will be influenced by the interest rate of each debt instrument. For example, if a company refinances an amount of debt at a significantly lower coupon, its leverage ratio will remain unchanged but its coverage ratio will materially improve.

 

Recovery

Debt to EBITDA

Loan-to-value

These ratios are used primarily to assess the likely recovery in the event of a default. In other words, they provide an indication of the likelihood that an investor would suffer a capital loss or not. The higher the value, the lower the probability of a full capital recovery in the event of a default.

Similar to a leverage ratio, it is important to note that a loan-to-value ratio has to be assessed in the context of the industry in which the company operates. For example, a loan-to-value ratio in the real estate sector, especially if using observable market valuation, would be a lot more reliable than a loan-to-value ratio where the assets considered are intangibles or other assets with limited to no market comparables.

Source: FIIG Securities

Non-financial covenants

Covenant

Purpose/Description

Dividend restriction

Ensures the issuer maintains sufficient equity, and bondholders remain senior to shareholders in receiving repayment.

Change of control

This condition is a safety valve for bondholders in the event of a merger, take over and transfer of interest. The provision gives bondholders the right but not the obligation to sell back the bonds to the company at a predetermined price (usually 101% of face value). In some cases it’s an automatic buy-back and not at the bondholder’s discretion.

Restriction on asset sales

Restriction on asset sales puts in place guidelines and conditions on the sale of assets. In some cases it may prohibit such events - in other cases it may require that sale proceeds are used to prepay bondholders.

Disposal

The disposal covenant restricts the ability of an issuer to transfer, sell or dispose of its assets. It assures bondholders that the asset base against which the debt was issued, remains intact.

Merger

This covenant is intended to restrict a merger where the resulting company is not financially healthy. It restricts the issuer from merging with another company or transferring its assets unless certain conditions are met.

Restriction on additional indebtedness

This limits the amount of additional indebtedness the issuer can incur or have outstanding, restricting the amount of new debt that can be acquired ahead of bondholders.

Negative pledge

This clause prevents the issuer from pledging its assets to a third party, thus reducing the level of security for bondholders.

Source: FIIG Securities

Conclusion

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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