Thursday 15 June 2017 by FIIG Securities covenantcastle Education (advanced)

Covenants and the protections they provide

Higher risk bonds come with additional protection which is important to understand. A detailed analysis of covenants is a crucial part of credit analysis and important in understanding a bond issue’s overall credit risk profile

What is a covenant?

Covenants are predominantly used in the high yield bond markets to give investors added comfort and protection in the case of financial difficulty. They are essentially restrictions on the borrower/ issuer imposed by the lender/bondholder that require the company to do or refrain from doing certain activities.

Covenants help protect investors when credit quality starts to deteriorate. That is when it might hinder the company’s ability to pay interest and principal in a timely manner.

Covenants can be deemed ‘tight/strong’ or ‘loose/weak’, depending on the terms and the financial flexibility they provide to the company.

Covenant analysis is a crucial part of high yield bond investment. A strong covenant package won’t outweigh a poor credit but it can provide significant protection. Conversely, a weak covenant package may not stop you investing, but there may be coupon step-ups that, where the company has a credit rating, help compensate if the company suffers a credit rating downgrade. It is noted that covenants typically come in two forms:

  1. Maintainence covenants: this means that at all times, the borrower/issuer must comply with its’ covenants
  2. Incurrence covenants: this means the borrower/issuer must comply with its covenants when new debt is incurred in the future. In the meantime, the borrower/issuer may in the course of normal business trade outside its covenants

It’s important to note each tranche of debt may have its own set of specific covenants, so I would suggest understanding the various tranches, including the covenants that relate to bank debt and how they might differ from the particular bond issue you are assessing.

Four key covenants to analyse

1.   Limitations on indebtedness

This covenant restricts the amount of indebtedness that an issuer can incur. Additional debt can weaken credit metrics and ultimately dilute the claims of existing bondholders via higher interest costs and debt repayments.

2.   Restricted payments

Restricted payments limit the amount the company can distribute money or assets outside the company, thus preserving it’s ability to pay its debts as and when they fall due. Types of payments that are controlled include: dividends, repurchases of equity, investments in unrestricted third parties  and repayment of debt that is subordinate or junior, before repayment of higher ranked debt.

The covenant doesn’t limit the company’s ability for capital expenditure or to make acquisitions.

Importantly, can the company make payments to equity holders as opposed to bondholders?

3.   Change of control

Change of control covenants are common, even with investment grade issuers. They protect bondholders in the event a weaker credit quality company takes over the issuing company. A change of control covenant requires the issuer to pay 101% of principal if a change of control event occurs.

Bondholders can accept or decline the offer. In essence the covenant gives bondholders the option to sell.

4.   Limitation on asset sales

Despite the name of the covenant, it doesn’t restrict the sale of assets but limits the use of the funds from sale to either permanently repay debt or purchase of other replacements assets.

The reason being the assets sold would usually generate cashflow to help service debt and any permanent reduction in those assets could negatively impact the capacity of the company to repay its debts.

What is the consequence of a breach of covenant(s)?

An unremedied breach will typically allow the note trustee, who is acting on behalf of the bondholders, to commence proceedings to appoint a receiver to the borrower/issuer within 60 days, depending on the type of breach.

Example – FIIG originated bond – Coffey International

Coffey International was an ASX listed global professional services consultancy that focused on international aid, infrastructure and a small amount of latter stage mining activity. The group went through some difficult times as its mining services business deteriorated along with commodity prices in late 2015. Coffey’s bond price fell to a low $86.30.

Fortunately, a large international aid business, Tetra Tech acquired Coffey early 2016. Bondholders could exercise a change of control condition and sell bonds at 101% of face value plus accrued interest.

Tetra Tech offered $106.50 per $100 face value to redeem the bonds, a good outcome for bondholders.

There were a number of covenants included in the documentation to help protect investors:

  • Notes may be redeemed prior to the maturity date upon a Change in Control of Coffey, by an investor putting notes back to the company at 101% of par, plus accrued interest
  • Limitations on further secured debt such that secured debt / EBITDA is not to exceed 3.0x on or prior to 30 Jun 2016 and 2.25x thereafter
  • No further debt unless the pro-forma interest cover ratio (EBIT / Interest) is greater than 3.50x
  • Dividend restrictions - max 50% of NPAT to FY17 and 70% thereafter, unless it is a fully underwritten dividend reinvestment plan
  • Restrictions on asset sales and application of proceeds

Example – USD high yield bond – Frontier Communications

Frontier is a US communications giant. It is a wireline carrier that offers voice, data and video services to residential and business customers. It acquired Verizon’s wireline assets in April 2016 for USD10.54bn. Market cap was USD1.45bn as at 9 June 2017.

The credit worthiness of the issuer is declining. However, the company is taking measures to boost its financial flexibility – it cut dividends by 62% and announced plans to issue new secured debt in 2Q17. Allowing it to pay down some of its near term maturities.

The business is deteriorating, suffering net subscriber losses of 43,000 in 1Q17 down slightly from 46,000 in the previous quarter.

To the end of 1Q17, Frontier had USD17.9bn of debt, USD341m cash and net debt of USD17.5bn.

Covenants in the new 2020, 2022 and 2025 exchanged bonds include:

  • Change of control at a purchase price equal to 101%
  • If the company or any of its restricted subsidiaries sell certain assets but do not apply thye proceeds in compliance with the supplemental indenture governing the applicable series of notes, we will be required to make an offer to repurchase such series of new notes at a price equal to 100% of the principal amount thereof, plus accrued and unpaid interest, if any, to the date of repurchase
  • Incur additional indebtedness, guarantee indebtedness or issue preferred stock
  • Create liens
  • Pay dividends, make certain investments or make other restricted payments
  • Enter into mergers, consolidations, or transfer or sell all or substantially all of our assets
  • Pay dividends on, or make distributions in respect of, or redeem or repurchase, capital stock
  • Make certain asset sales
  • Enter into restrictions affecting the ability of our restricted subsidiaries
  • Engage in transactions with affiliates

In addition, the company’s credit facilities also require them to comply with specified covenants, including financial ratios.

The company is currently rated sub investment grade. There is a further clause which allows for suspension of the covenants at any time after the notes of such series achieve investment grade ratings by at least two of Moody’s, S&P or Fitch, provided at such time no default or event of default has occurred and is continuing.